The trouble with bond yields

The “Great Rotation” has begun, say investment strategists at some of the world’s largest investment banks.

Expectations are growing that shares, which have performed poorly in recent decades, will once again provide strong returns and that the long bull market in government bonds will end, sending their yields back up to more “normal” levels.

Yields on quality sovereign bonds – those issued by countries such as the UK, US, Switzerland and Germany – have indeed risen lately; on 10-year gilts, for instance, they reached 2.07 per cent this week, while the yield on the 10-year US Treasury note topped 2 per cent for the first time since last April. Yields are the inverse of prices, so rising yields mean falling prices.

But what do we mean by “normal” levels? The question is a vital one, since returns on government bonds effectively dictate returns from everything else. Is “normal” the average yield over the past 30 years, a period that would encompass the adult lifetimes of many people seeking investment advice today? What about the past 50 years? The past 100? Or should “normal” mean what bond yields are in economies with characteristics similar to ours?

Companies that run defined-benefit pension schemes have strong views. They think current rates are abnormally low and that this is artificially inflating pension fund deficits with all sorts of negative consequences (see panel). But what about others?

. . .

Define normal

“Normal,” according to John Llewellyn, principal at economic adviser Llewellyn Consulting, “is a little bit like the joke about the elephant. I can’t describe it but I’ll know it when I see it.”

In economic theory, the yield on a risk-free government bond should roughly equal the rate of growth in the economy, plus the rate of inflation. Until recession hit the UK in the second quarter of 2008, economic growth averaged 2 to 2.5 per cent over the long term, slightly higher in the decade to 2007. Add on 2 to 3 per cent for inflation and “normal” bond yields should be about 5 per cent, perhaps higher.

But that’s just the past few decades, and bonds have been around since the 15th century. Some economists say we should be wary of placing too much reliance on relatively recent history, a tendency that psychologists term the “availability heuristic”. It is this tendency that allows investment bankers to believe their balance sheets were sound enough to withstand the risks they took in the years leading to the financial crisis, or homeowners the world over to think that house prices would only ever go up.

. . .

It’s not unusual

If we look back beyond recent history, we might come to different conclusions about the returns government debt should offer. A quick look at yields on consols – perpetual UK government bonds that were the predecessors to today’s gilts – reveals that in the 19th century these broke through 5 per cent only in 1812 and 1816, the years of the (very expensive) Napoleonic wars.

By the end of the 19th century, they were below 3 per cent again. Moreover, double-digit yields prevailed only for a very brief period in the 1970s through the late 1980s, when inflation was high. As our timeline shows, over the past 300 years, high rates are abnormal. Those in low single-digits are “normal”.

Alisdair MacDonald, head of UK investment strategy at actuarial consultants Towers Watson, said that the current debate about rates is similar to the one about equities in 1999, just before the technology bubble burst, when some argued that stock markets had reached a “new normal” in terms of equity valuations.

Current low rates, he said, do have historical precedent. In 1945, 10-year US Treasury yields were 1.5 per cent, about where they are now. The central view at Towers Watson is that as growth picks up, rates will eventually rise. “But people think that we will see real (above-inflation) rates of 2 to 3 per cent and we don’t think that will be the case,” MacDonald said.

A sustained rise in yields would require a sustained fall in prices and catalysts for that are hard to spot. Rising bank base rates would harm gilts, but given the UK’s poor economic performance, there does not appear to be any reason to expect the Bank of England to begin raising interest rates any time soon.

Another catalyst might be the unwinding of the Bank of England’s large gilt positions – it has acquired £375bn of gilts since March 2009 under quantitative easing – but this also looks some way off. Some of those securities will disappear as they mature, with the first lot set for redemption in March.

. . .

Still in demand

Meanwhile, demand for gilts and similar “safe” assets remains very high, for several reasons. Demographic change is one. As the populations of industrial nations reach retirement age, savings that once poured into equities markets are transferred to lower-risk investments, such as bonds.

Recent research by economists at Credit Suisse and BlackRock points to a strong correlation between the ratio of the working-age population to that of people in retirement and the general direction of interest rates. As that ratio falls, so too do bond yields.

Then there is the savings glut elsewhere in the world, particularly Asia. In a prescient 2005 paper, professors Ricardo Caballero of MIT and Arvind Krishnamurthy of Northwestern University’s Kellogg School of Management predicted that what they described “an insatiable hunger for safe debt instruments” growing out of the Asian crisis of the late 1990s. Savers in those countries, scarred by the collapses in local currencies, wanted to hold their savings in dollars, pounds, yen, Swiss francs and euros. That’s created huge demand for safe assets denominated in such currencies.

Finally, there is “financial repression”, where governments and regulators force financial institutions to hold safer assets as a capital buffer. So even though the supply of government debt is copious and growing, there is no shortage of demand either. All that keeps prices up – and yields down.

. . .

Is there a normal?

Some think the very concept of “normal” interest rates is open to question. “I don’t think there is such a thing as ‘abnormal’ interest rates,” said Adam Posen, president of the Peterson Institute for International Economics and a former member of the Bank of England’s rate-setting committee. “What the central bank’s interest rate should be depends upon the economic context. It’s about appropriateness, not so-called normality.”

It is a view that many private sector economists share. “There is no proper definition of “abnormal” and you would expect economic depression with low nominal GDP growth to produce low yields,” said Michael Saunders, economist at Citi.

And a look at yield histories around the world shows why “normal” is so hard to define. Long-term US bond yields fell below 2 per cent in the aftermath of the attack on Pearl Harbor, and did not rise above 3 per cent until 1957. Over the past 40 years, US 10-year government notes have carried an average yield of 6.73 per cent – but that encompasses a period of raging inflation following the end of the gold standard and the oil price shocks.

More recently, yields have been lower – averaging 5.17 per cent since 1992 and 4.05 per cent since 2002.

Then there’s Japan. From 1972 to 1992, yields on Japanese government bonds averaged 6.96 per cent. But in the 20 years since the bursting of the real estate bubble, average yields have been under 2.0 per cent, averaging 1.974 per cent since 1992 and 1.34 per cent since 2002. In that context, the current ultra-low rates here don’t look out of the ordinary – especially since our own economic trajectory is starting to look worryingly similar.

MacDonald believes that while it is unlikely that the UK will end up like Japan, it is not impossible. He puts the odds of such a lengthy stagnation – of both economy and yield – at about one in five.

. . .

Why yields matter

Ordinary individual investors owning mostly shares and funds may wonder why the history of bond yields matters so much. There are two reasons.

One is that government bond yields form the basis of pension fund accounting. The ballooning deficits on corporate pension schemes, the accelerating closures of defined-benefit schemes, the huge unfunded liabilities in public sector pension schemes and the well-documented collapse in annuity rates – these are all a partial consequence of the steady decline in gilt yields over the past decade. Since pensions form the basis of most people’s retirement planning, and the funds that pension providers run are still among the biggest investors in the stock market, practically everyone is impacted by low yields, even if they don’t realise it.

The other is that in asset-pricing theory, the yield on government bonds is taken to be the risk-free rate of return. Expected returns on just about everything else are benchmarked against the return that could be obtained by taking no risk (the theory being that the government will never default, since it can always print money to pay its debts).

If the risk-free rate is to remain at current levels, or return only to levels that were typical before the 1970s, that suggests long-term returns from other asset classes such as equities – which effectively consist of a risk-free rate plus an “equity risk premium” – may also need to be recalibrated. Lower bond yields could therefore mean structurally lower long-term rates of return from all assets. That would leave investors having to take more risks, save for longer, or simply save more.