What Are Low Bond Yields Trying to Tell Us?

The yield on government bonds in the U.S., U.K., and Germany is at or near record lows, yet investors continue to snap them up.

It's hard not to suspect this mania for bonds has come at exactly the wrong time from the standpoint of healthy future returns. Last year's Barclays Gilt Equity Study showed the return from gilts (U.K. government bonds) was higher than equities over a nearly unheard of two-decade period to 2009. Even more shocking is that it was the same story in the 2010 study -- even after the massive rally in stocks from March 2009.

For the de facto risk-free asset class to beat the rewards of taking a punt on equities over such a long time period flies in the face of economic expectations over the past 50 years. Shares have been in the doldrums for decades, but bonds have enjoyed a spectacular bull run.

Open to interpretation
Of course, equities could have been too expensive a couple of decades ago, and given the steep fall in inflation expectations, gilts too cheap.

But that was then, this is now, and there are as many theories as to why gilt yields are low today as there are buyers.

Some point to pension fund buyers who have turned their back on equities. Personally, I think quantitative easing must have played a role -- lowering long-term yields is a key part of the QE theory. And Andrew Neville, who runs the Allianz RCM U.K. Mid Cap Fund, outlined four more reasons at the recent Growth Company Investor show in London.

Showing a slide illustrating the ever-falling government bond yields, Neville said:

"I think this slide is the most important issue facing us in the market today. If we don't have a view on it, we'll possibly struggle to take a view on the market itself. We can debate all day what this is telling us, but it's telling us something."

Here are the four explanations he sees competing to justify the record low government bond yields.

1. Deflation
Neville doesn't think it's very likely, but he concedes that deflation is the most obvious interpretation of low bond yields, which he thinks is also backed up by gold passing $1,300 and similar runes.

If deflation really is ahead, he warns, looking for opportunities in equities is "a waste of time. The only thing in my mind you can hold in a deflationary environment is cash. That is what Japan has taught us."

2. Capital preservation
Another potential interpretation of the record lows on government bonds is investors seeking capital preservation. "Entirely possible," Neville says, "although I would point out that corporate bond spreads are still narrow and narrowing."

Neville says investors seeking capital preservation presumably fear a recession in the next 12 months, which should include corporate bond spreads widening. So he doesn't give this explanation much weight.

3. Demographics
A demographic shift in the Western world is one of the two explanations that Neville considers likeliest: "We are all getting older, and therefore pension funds want to hold more fixed-income as a proportion of their portfolios."

Neville sees this in the pension funds of FTSE 100 companies. Three years ago, they were 33% invested in fixed-income, he says, whereas now they're up to 50% -- including government debt -- "and moving upwards."

4. Surplus Western currencies
This one is a bit complicated, so I'll quote Neville directly -- especially since he believes it's the correct interpretation of low government bond yields:

"Companies around the world are very nervous about the policy they're seeing from Western governments, particularly the Fed. [We] seem to be in a situation of competitive devaluation of [our] currencies. Emerging market companies do not want to hold devaluating currencies as an asset. They have to hold dollars, euros, and pounds to trade, but any surplus currencies they've got, they'll convert to their own currency with their central bank.

[Therefore] the central banks around the world have got too many dollars, too many euros, too many pounds. They cannot sell them to anyone -- there are no buyers. All they can do is buy government debt. They'll start at the short-end, the two-year, because they know they get that back at par. They've [already] brought the yield on that down to next to nothing. They then roll out.

I think that's what's happening, and I think that's why the yield curves are coming down very quickly."

Low yield, big deal
One thing that makes markets so fascinating is that "once in a lifetime" opportunities and oddities seem to come along every few years. In the past decade we've seen the dot-com peak, a surging gold price, and the first bank runs for a century. The record low yields on government bonds could be the most important of all.

It's impossible to reach a consensus, even on the starting points. For instance, I'm unconvinced by Neville's pension fund argument -- the drop in the proportion of their funds in equities over the past three years could surely just be down to lower share prices. I think gold investors are more worried by inflation than deflation, too.

Neville himself stressed that the answers aren't obvious. "I favor the bottom two explanations, and there are perfectly sensible people who favor the top two," he admits.

So it's time to make up your mind. If you decide deflation is in the cards, your portfolio will probably look very different to one that thinks emerging markets are awash with surplus Western government currencies.

Alternatively, perhaps it's best to spread your bets. But that's also a decision!

This article has been adapted from our sister site across the pond, Fool UK.


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  • Report this Comment On October 02, 2010, at 8:32 AM, predfern wrote:

    The Dow went up in September and commodities went up even more. The dollar is being devalued.

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