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BONDS: A SECULAR OPPORTUNITY
CHART OF THE WEEK: "The cumulative negative bond return is off the chart"
BOND MARKET ANALYSIS
Never in the memory of investors have bond markets experienced such a bad sequence, and so rapidly. All bond yields have risen to near their highest levels in the last ten years (see Fig. 2). With bond performance moving in the opposite direction to yields, the global debt benchmark tracked by Bloomberg has contracted by -21% in less than 10 months, down -25% from its peak in January 2021 (see Fig. 3). For US Treasuries, which have a longer track record, the cumulative negative performance of -18% is slightly less severe but just as impressive by historical standards (see Chart of the Week).
Usually, it is risky assets and not fixed income that deliver these kinds of red numbers. The reasons for such a setback are well known: an increase of the debt supply, a rise in key rates to fight inflation, a programmed end of bond purchases by central banks, a lack of investor interest in this asset class given the low yields for so long, a rise in credit risk premiums, a deterioration in the solvency of emerging countries with the appreciation of the dollar, etc.
Among all these factors, the initial low yields were the most damaging: the coupons offered no support to performance. In concrete terms, when yields rise from 7% to 10% (+300 bp), the depreciation in the price of the bond is partially offset by the payment of the coupon. Conversely, when yields rise from 1% to 4% (also +300 bp), the buffering effect is small. Such a situation had never been experienced since the recording of bond data records began... in 1870 (see Fig. 4).
Within the different categories of bonds (see Fig. 5), those issued by governments whose central banks have been the most accommodating fare better. This is obviously the case for Japan, whose sovereign rates are artificially controlled to keep them close to zero (Yield Curve Control) and, to a lesser extent, Switzerland. With the Swiss currency appreciating and inflation and debt remaining low, yield increase has remained moderate. At the other end of the spectrum, emerging market bonds suffered from the appreciation of the dollar as it eroded the solvency of governments and companies whose revenues are in local currencies. British bonds were hurt by the lasting consequences of Brexit, political imbroglio, rising public spending and tighter monetary policy.
High yield bonds, by definition the riskiest bonds, did not lose out: their performance was no more negative than the rest of the market. This is unusual. As proof of this, spreads are lagging far behind the market's volatility (see Fig. 6). Their appealing yields have attracted some investors. It would therefore not be surprising if high yield bonds suffer further over the next 12 months.
The bond bear market has been so severe that it offers a secular opportunity. Better still, the asymmetry of the situation makes it possible to take a lower risk. Let's look at the two ends of the spectrum:
- In a very optimistic scenario (i.e. the worst case for bonds), central banks would continue to raise policy rates to fight inflation, while governments, companies and households would manage to shoulder the additional debt burden. Under this assumption and according to the most optimistic contributor to the Bloomberg consensus (see Fig. 7), 5-year sovereign bond yields in dollars could rise to 5.3% by the end of 2023.
- In a very pessimistic scenario (ideal for fixed income investments), in which the stability of the financial system is at risk, central banks would suddenly stop their strategy of normalising monetary policy and "pivot" to bring policy rates close to zero and control the yield curve by starting a new quantitative easing. Under this assumption, which is the one towards which our analysis converges (see Fig. 8), 5-year US sovereign bond yields could fall to 1.9%, as HSBC also expects.
Under the least favourable scenario of a rise in rates to 5.3%, an investment in 5-year US Treasury bonds would not result in any additional loss by the end of 2023: +0.2%. Conversely, if rates fall to 1.9%, the expected return would be +12%. Between these two extremes, there is a whole range of returns (see Fig. 9).
It's worth the money: the asymmetry between risk and return has rarely been so attractive. Investors who had turned away from bonds in favour of equities or so-called "alternative" strategies will not fail to notice. As capital flows back into the market, the bond bull market could even be quite rapid.
Conclusion
Investors are still reluctant to take a look at the global bond market claiming the risk of a crash. They may be forgetting that the crash has already occurred and that it has paved the way for a secular opportunity. TINA (There Is No Alternative) is gone, welcome TIFFANI (There Is a Fast and Furious Alternative Not Insane).
RETURN ON FINANCIAL ASSETS
