By ROBERT HARLEY 10/09/2010
Bond yields in all the major developed markets fell to record low levels over the month. Weaker US economic data combined with the resumption of US treasury purchases by the Federal Reserve have been contributing factors driving down US Government treasury yields with other developed world bond markets following their lead. With yield levels now at levels not seen for over 20 years (2.6% for 10 year US Treasuries, 2.2% 10 year German Bunds, 2.9% 10 year UK Gilts) talk of a bond bubble has come to the fore. Admittedly, at these prices, long term returns on government bonds are likely to be poor. However this does not necessarily suggest a bubble.
Government bond yields are a function of growth and inflation, historically bond yields have tended to broadly match nominal economic growth rates, that is growth including inflation. If this is expected to fall, then it is quite possible that these yields represent fair value and prices could rise even further forcing yields down if the economic environment deteriorates further, resulting in additional shorter term gains for investors. Whilst we are not trying to draw parallels with the Japanese experience we can see just how low these yields can potentially go – the Japanese 10 year Government Bond is currently yielding just 1.1%.
Some fixed income managers argue that at these levels ‘western’ government yields are already pricing in a sustained period of very low inflation and even a double dip, consequently the bad news for the economy - or the good news for holders of government bonds is already reflected in their prices. Obviously others argue there is still more to play for, indeed history tells us that the aftermath of a banking crisis tends to be characterised by a low / negative economic growth environment, until banks have managed to repair their balance sheets, a process which can take several years.
However, interpretation of the current environment has been made more complex as a result of the aggressive steps that Governments and Central Banks have implemented or have indicated they will take to protect the economy and guard against deflation. In the near term these measures are designed to keep bond yields low whilst at the same time kick start a sustainable economic recovery. At some point these actions, if consistently returned to and applied in large doses, are likely to be inflationary, with negative consequences for government yields.
Bestinvest’s view
Trying to assess the size and timing of any inflationary impact is a formidable task. We believe government bond yields currently offer little room for error, consequently we are inclined to take a more cautious view, but at the same time it is too early to start focusing on inflation as a threat. Against this backdrop we favour strategic bond funds, essentially best idea bond portfolios, that provide managers with the flexibility to negotiate a highly uncertain environment. We would also point out that if at some point bond markets do suffer a serious reversal, it does not automatically follow that equities will prove to be a safer haven investment.
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