Ask any multi-asset investor why they buy high-quality government bonds and I would be shocked if ‘supporting portfolios when equities fall’ was not one of the top reasons cited. This is premised on history: sovereign debt has tended to perform well after a negative shock to economic growth. However, with government bond yields already close to the floor, there’s a crucial question of how much lower they can go.
At some point, bonds’ potential to rally further wanes and they lose some of their appeal for us. How low yields can go differs by market and is a function of the preferred policy tools of the central bank in question. We feel that Japanese government bonds closed in on the floor years ago, and now their Germany counterparts may be going the same way.
After decades of dropping, Japanese 10-year bond yields finally fell below zero in 2016 and since then have trodden a very narrow range of just 0.45%. We think that change in behaviour reflects the perception that there is a barrier in place stopping yields falling much further. As such, we believe Japanese bonds now offer investors little help during economic or equity downturns. Implied volatility, a measure of the market’s perception of the potential breadth of future outcomes, has similarly collapsed.
Bunds of steel?
We now think German bunds are reaching a similar status. Their yields are already well below Japanese levels, largely because the European Central Bank (ECB) has been prepared to cut interest rates much lower; they are currently -0.5% for the overnight deposit rate.
However, in 2020 the ECB surprised markets by not cutting further and we think that implies the barrier to going further is high. With that in mind, we think bunds’ risk-mitigation properties have faded and with that, their main role in multi-asset portfolios. For example, 10-year bunds have returned about 3% this year, compared with over 10% from their US equivalents, which started at much higher yields, and so had further to fall.
The issue is particularly acute at some points on the yield curve, with yields below -0.7% out to seven years. That means Eurozone investors who hold the bonds to maturity can expect a materially lower return than if they just held cash at current deposit rate levels.
We think that makes those bonds pretty unattractive for multi-asset investors, as they provide limited risk mitigation and a negative expected return relative to cash.
Our base case would be that other bond markets face a similar fate in the next few years. If that’s the case then risk management will continue to become harder for investors, and there will need to be innovative approaches to plug the gap that high-quality bonds have left.