This month we have taken a section from Richard Scott’s article in the Hawksmoor Quarterly Investment Update. It addresses the current situation on the bond market and the investment opportunities that arise.
The effect of the crisis on government bond markets
Perhaps the most dramatic consequence of the slow-drawn out nature of the crisis that has unfolded since 2007 has been the sharp drop in most sovereign bond yields. In June the yield on the UK’s 10-year gilt fell to 1.5%, the lowest level since the Bank of England was established over three hundred years ago.Yields on the government bonds of the European countries with the strongest public finances fell to even lower levels. Indeed, 2-year government bond yields in Germany and Switzerland fell below zero,meaning that investors were prepared to pay these countries for the privilege of lending them money! While authorities would like to see low bond yields as a sign of investors’ faith in the soundness of their economic policies, these extraordinarily low yields are an indictment rather than a vote of confidence in the economic future. Low yields reflect pessimism about the likely success of attempts to revive growth rather than increasing confidence in the health of public finances and the authorities’ economic competence.
Many now believe that Western economies will be condemned to many years of virtually no growth, with interest rates and bond yields remaining low, as has been the case in Japan for the past two decades.However, the consistent inaccuracy of the Bank of England’s inflation forecasts over recent years is just one of many examples of the errant nature of most economic predictions. Low bond yields cannot be explained solely by changes in consensus economic forecasts. Other reasons for the sharp drop in bond yields include the increased buying of government bonds for regulatory reasons by institutions such as banks, insurance companies and pension funds, and the impact of the policy of quantitative easing,which has resulted in the Bank of England owning around one third of all the gilts in issue.Thus, while the weakness of the economy has resulted in the UK Government having to issue more gilts, due to a large deficit between public spending and tax receipts, the Bank of England has more than offset the negative impact this would normally have had on gilt prices by its huge gilt buying programme. With the US Federal Reserve following the same policy, it is this dynamic that has led some to describe the market for government bonds as being rigged.
The theory of a rigged government bond market rests on the understanding that it benefits the authorities to keep bond yields low, and beneath the rate of inflation (i.e. targeting negative real bond yields). In this way the burden of debt is steadily eroded in real terms, echoing the policy followed by some western governments in the aftermath ofWorldWar II,when bond yields were also negative in real terms for a long time.This policy, sometimes termed ‘financial repression’, is effectively a form of surreptitious taxation, involving transferring money from savers to debtors. While the authorities may again prove successful in maintaining low and negative real bond yields, their success cannot be guaranteed.There is a significant risk of the rapid upward moves in bond yields in countries including the US and UK that have already been witnessed in places like Spain and Italy.As such we believe sovereign bonds at record low yields are unattractive,with asymmetric risks due to minimal upside and considerable downside. With the authorities determined to prevent deflation, there seems little chance of earning a positive real return even if yields remain at record lows.Moreover, there is significant downside risk to capital should circumstances such as stronger economic growth,or a loss of confidence in the sustainability of the health of public finances, cause yields to rise. Quantitative easing has played a large part in the fall in gilt yields, and it is hard to see how the policy can be reversed without a negative impact on the value of gilts. (For example, if the yield on the 10-year gilt were to rise to 5%, it would result in an immediate loss of capital of around 25%).
Finding opportunities in bond markets
It is important to remember that government bond yields are around record lows when evaluating other opportunities in bond markets. This is because in many cases other bonds, such as those issued by companies, only appear ‘cheap’ in relation to expensive government bonds, rather than being truly attractive. Examples of such bonds include a number issued by companies at interest rates some way below the yields available on the same company’s shares. For example, in May GlaxoSmithKline issued $2 billion of 10-year bonds at an interest rate of 2.85% compared with the dividend yield of 4.8% on the company’s shares. Logic would suggest that the buyers of these bonds must believe that GlaxoSmithKline is a sufficiently poor company to see its share price fall over the next decade, and for it not to be able to at least maintain the dividend on its shares. However, they must also believe GlaxoSmithKline remains sufficiently creditworthy to service its bonds. By contrast we believe the shares are too cheap while the bonds are overpriced, and the relative valuations illustrate short-termism created by the general mood of risk-aversion.We view the opportunity for strong companies to issue bonds at such low interest rates is advantageous and in the long term should enhance their enterprise value. Good companies use periods of economic difficulty to strengthen their competitive position, and taking advantage of record low borrowing costs is an example of this.
The low borrowing costs available to major multi-national companies are not typical across debt markets and there are numerous opportunities to buy bonds in strong companies at attractive yields. One of the most striking features of the current economic backdrop is the resilience of much of the corporate sector.This contrasts with the situation in 2008 and 2009, when the sudden worsening in conditions caught out many companies at a time when their finances were stretched. Many companies now have much stronger balance sheets, and are better positioned to weather difficult times, making their bonds, typically at yields between 5% to 8% above those of government bonds, attractive investments. In 2009 the percentage of companies not paying the interest on their bonds (defaults) peaked at around 12%.While defaults have been rising recently they remain less than 3%, up from a low of 1.8% in October 2011. Other areas of bond markets where we are finding good opportunities include some bonds of emerging market countries with undervalued currencies and sound finances, and inflation linked bonds providing security, albeit not cheaply, against one of the main longterm risks facing investors -a significant rise in the rate of inflation.