Why bonds are running wild

Following last week’s drama in global bond markets in which yields slid precipitously, then rallied again, Berkshire chair Warren Buffett had this to say in his annual shareholder letter: “Fixed-income investors worldwide — whether pension funds, insurance companies or retirees — face a bleak future.” Bond yields are now so low that investors have to look elsewhere to earn a return, which is partly why equity and commodity markets have enjoyed their incredible gains of the past few months. But, warned the Sage of Omaha, “some investors may try to juice the pathetic returns now available by shifting their purchases to obligations backed by shaky borrowers. Risky loans, however, are not the answer to inadequate interest rates.” Why are these formerly staid markets so wild? And what does this mean for the once typical investment portfolio of 60% in equities and 40% in bonds? The FM spoke to Futuregrowth chief investment officer Andrew Canter.

What is the import of the huge swings experienced by global bond markets last week?

AC: The thing about any investment, whether it’s property, a bond or an equity, is that the best indicator of your future return is your starting yield. So if a 10-year bond yield is at 1.5%, your best estimate for the coming years is a return of only 1.5%. The other reality is that the yields can’t really go much lower.

We see negative yields in some markets, but where do you go from there? It’s very hard to see a rally in bonds [yields going down and prices going up] in a global recovery. That’s what Buffett is saying — the outlook is skewed towards risk, not return.

Also, it’s pretty evident that the dramatic fall in cash and bond yields has also been the impetus to push up all other asset values. There is so much money floating around the global financial system, because people are stuck at home and they’ve had stimulus packages [in the US] that money is leaking out and showing up in places like bitcoin, online trading and some crazy stuff. It’s a form of inflation: too much money is chasing up the price of financial assets.

What has changed in the past six weeks is the realisation that mass vaccination is rolling out and economies are going to move back to normal. The enormous amounts of money that have been pumped into developed economies and the pent-up demand mean that economies are likely to reopen strongly. We’ve had an incredibly sharp recession that has shaken out weak competitors across industries. Less competition and rising demand is a recipe for inflation.

I’m confused, though: if there is inflation on the horizon, don’t central banks need to hike interest rates? So why are they doing their utmost to keep yields down?

AC: They want low rates to give economies a boost. They’ve pushed rates down by cutting short-term rates and buying long bonds. That lowers the cost of capital and supports the economy. But they only have that wiggle room to manipulate rates as long as there’s no actual inflation.

Once inflation starts picking up, if central banks want to maintain any sort of long-term credibility they will be forced to start pushing rates up. It takes away the fun. The first interest rate hikes we are going to see are “good-news rate hikes” — as economies recover, things look better, so bond yields rise. The bad-news rate hike comes when there’s actual inflation; though I think it’s premature to panic about that. But these are the things to watch.

Going back to Buffett’s point — isn’t it a nightmare for pension funds? What do savers do?

AC: I think it oversimplifies how pension funds should be run — based on long-term assets which are held to make future pensioner payments. [But] if you were starting to save for your retirement now you’d have to save more, because you’re looking at low expected returns.

Are bonds still a safe bet, though? Are they still what MoneyWeek editor Merryn Somerset Webb calls “anti-fragile”?

AC: Last year, when the equity markets plummeted by 30%, bonds rallied as interest rates fell sharply. Equities got clobbered, but you made a lot of money in bonds.

Bonds, by and large, in times of economic crisis will act contrary to equities, so they are a risk stabiliser in a retirement fund. I don’t think anybody’s abandoning the idea of a balanced pension fund.

However, the definition of a “balanced fund” has evolved to include a wide mix of equities, bonds, credit, property, inflation-linked assets, and alternative assets like venture capital, private equity, infrastructure and absolute return funds.