Investment report: betting on bonds

Do they make sense today?
January 27, 2020

If there is sense and sensibility in investing, bonds are undoubtedly the choice for Jane Austen’s grounded Elinor rather than her flighty Marianne. In modern times the regular income they provide has made them a bedrock of portfolios for those wanting to avoid the sturm und drang of volatile equities. But do they make sense today, when trillions of dollars of bonds worldwide offer outright negative yields if held to maturity?

The worry is that bond prices, which are inversely related to their yields, are perilously high. Maybe they can climb a little further, buffing the established capital gains of the funds that hold them. Or they could fall a long way, denting the wealth of those who depend upon them. Reaching a view on the merits of bonds is crucial for investors in 2020. These longer-term forms of debt, issued by governments and companies, traditionally provided ballast to steady returns. A commonly followed rule in “sensible” retirement planning is to hold an increasing share of savings in bonds when approaching pensionable age. 

But time-honoured practices may no longer work in the strange era of negative bond yields. Though these are essentially a eurozone and Japanese phenomenon, yields elsewhere reached historic lows in 2019. Those on 10-year gilts issued by the British government fell to around 0.4 per cent. At such nugatory levels, returns rely primarily on further price rises, but their logical corollary is still-lower yields. You can try to offset them by holding higher-yielding corporate bonds, but these expose you to the risk of firms that have issued them going bust. 

Despite these real concerns, some current anxieties about investing in bonds are overdone. Though gilt yields have moved up from the depths of last year, they were still only a meagre 0.75 per cent as 2020 dawned. For years investors have been wrongly fretting that bond yields are unnaturally low and will rebound, driving prices down. Back at the start of 2017, yields on 10-year US government debt looked set to rise from around 2.5 per cent as the newly-elected President Trump eyed a borrowing splurge. In the event, though they broke 3 per cent at times in 2018, in 2019 they sank back below 1.5 per cent and started 2020 below 2 per cent. 

The world of ultra-low interest rates shows little sign of disappearing. Population aging is a structural force holding rates down. A bulge of middle-aged people, who typically save more, has pushed up savings, while investment opportunities have diminished as fewer young people join the workforce. The resulting downward pressure on bond yields should eventually abate as more baby boomers retire and run down savings, but the process is an inherently gradual one.

There are also more immediate forces constraining yields. Global trade growth has slowed to a virtual standstill and the world economy looks stuck in a low-growth rut. The US Federal Reserve and other central banks eased monetary policy still further last year and are on standby to deliver yet more stimulus, bearing down on both short- and long-term interest rates.

As developed economies turn Japanese, with very low inflation and interest rates, it is worth learning lessons from this demographic forerunner, whose working-age population started to fall more than two decades ago. Since then bond yields have subsided and investors hoping to gain from a reversal in the trend have fared so badly that their strategy was dubbed the “widowmaker.” Global bond markets may appear scarily overpriced, but betting against them this year may be even more dangerous.