by But investors should keep in mind that yields on government bonds could easily spike Global bond yields have plunged to new lows in recent days, as markets have switched to ‘risk off’ mode. This is just the latest manifestation of a trend: sovereign bond yields have been under downwards pressure for several years. Central bank QE and economic uncertainty are partly to blame. But investors should remember that sovereign bonds are not risk-free assets. And yields could easily jump over the summer.A sign of the timesAs global economic growth has lacked momentum over the past few years, and inflationary pressure have been muted, interest rates on sovereign bonds have been pushed lower and lower — and increasingly into negative territory.Around USD8trn out of USD23trn of DM sovereign bonds currently have negative yields, or over one-third[1]. Around half of the sovereign bonds in negative territory are Japanese, but this is not just a localised phenomenon. German bonds account for more than 12% of the total amount of sovereign bonds with negative interest rates. As of market close on 10 June, the country’s sovereign bonds were “in the red” up to 9 years maturity—and at 0.02%, the 10-year Bund was on the brink[2].
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Christophe Donay considers the following as important: bond yields, low bond yields, Macroview, negative interest rates
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But investors should keep in mind that yields on government bonds could easily spike
Global bond yields have plunged to new lows in recent days, as markets have switched to ‘risk off’ mode. This is just the latest manifestation of a trend: sovereign bond yields have been under downwards pressure for several years. Central bank QE and economic uncertainty are partly to blame. But investors should remember that sovereign bonds are not risk-free assets. And yields could easily jump over the summer.
A sign of the times
As global economic growth has lacked momentum over the past few years, and inflationary pressure have been muted, interest rates on sovereign bonds have been pushed lower and lower — and increasingly into negative territory.
Around USD8trn out of USD23trn of DM sovereign bonds currently have negative yields, or over one-third[1]. Around half of the sovereign bonds in negative territory are Japanese, but this is not just a localised phenomenon. German bonds account for more than 12% of the total amount of sovereign bonds with negative interest rates. As of market close on 10 June, the country’s sovereign bonds were “in the red” up to 9 years maturity—and at 0.02%, the 10-year Bund was on the brink[2].
Negative interest rates are one of the most unintended consequences of the policy response to the subprime crisis — notably central bank Quantitative Easing (QE) — and a major hazard for investors. Would investors really have expected to find themselves paying to hold the sovereign bonds of states that are heavily indebted and have rising budget deficits (notably the case with Japan)? Modern finance tells us to ask for compensation to offset the risk taking when buying a risky asset.
And sovereign bonds are risky assets, on two levels. First, the states issuing bonds could default. Greece is far from an exception in economic history. Core sovereign bonds have never defaulted, but it is not impossible. Second, returns on sovereign bonds are not guaranteed, as they are negatively correlated to the evolution of long-term interest rates.
Asymmetric risks
From this perspective, the interest rate risk investors bear on sovereign bonds is becoming asymmetric. The interest rate on US Treasuries can be divided into two parts: inflation break-evens and Treasury Inflation-Protected Securities (TIPS). Recently we have seen a certain de-correlation between TIPS and Fed fund futures on the one hand, and between break-evens and the oil price on the other.
This puts the bond investor at risk, as these two interest rates could re-correlate to fundamentals. Fed monetary tightening, expected in July or September, could increase the TIPS interest rates, while higher crude oil prices could push up inflation break-evens. In combination, this could lead to a painful spike in long-term bond yields.
Despite these risks, long-term interest rates continue to fall for the moment. Why? For two reasons. First, central banks’ asset purchase programmes — in Japan and the euro area — are absorbing part of the supply. The negative interest rate phenomenon is set to take stronger hold in the euro area as the ECB begins buying corporate bonds this month. Second, heightened uncertainty, notably at present in connection with the Brexit referendum on 23 June, increases the attractiveness of core sovereign bonds as a protection asset (since they are negatively correlated with equities) in a way that is completely out of line with economic fundamentals.
These factors will continue to damp sovereign bond yields, adding to the difficulties faced by investors in what is already a very challenging environment for generating returns. But there is still a significant risk of an abrupt turnaround.
[1] JPMorgan GBI broad index
[2] Bloomberg