Desperate search for yield keeps global bond prices high

London

THE global sovereign-bond bull market has embarrassed numerous market strategists, fund managers and other forecasters who were bearish at the beginning of the year. At the start of 2014, the vast majority of forecasters including BOA Merrill Lynch, Morgan Stanley and BlackRock predicted higher yields and lower bond prices.

Instead, US Treasuries and European and Asian long-term government bonds have generally outperformed equities, gold and junk securities. Since the beginning of 2014, medium-term US Treasury bond exchange-traded funds (ETFs) with redemption periods of seven to 10 years have risen by 7 per cent and 20-year Treasury bond ETFs by 17 per cent.

When bond yields decline, the prices of the securities rise and the longer the duration of a bond, the larger the price gain when the yield falls. When yields rise, the opposite occurs.

In 2013, fears that the US Federal Reserve Board would start "tapering", that is reducing bond purchases, brought in their wake a sharp increase in yields and price declines.

But that was a buying opportunity. Yields have since tumbled from their highs that year and global prices have surged. Thus, as the table shows, 10-year US Treasury bond prices have risen by 7 per cent since 2013, German bunds by 14 per cent, UK 10-year gilts by 8 per cent, French government bonds by 15 per cent, Italian by 21 per cent, Swiss and Japanese by 20 per cent, Australian and Canadian by 10 per cent and Singapore 10-year government bonds by 5 per cent. Including interest, the gains are even better.

Europeans, Japanese, and other Asian and South American investors who purchased US Treasuries would have also made large profits from the appreciation of the US dollar.

Following the price surge and yield drop, bond valuations are now rich. In real, inflation-adjusted returns, Italy's real yield of 2.27 per cent followed by Singapore's (1.72 per cent), Australia's (1.13 per cent) and the UK's (1.01 per cent) offer the best values. Japanese 10-year government bonds are the most overvalued by far, with negative real returns of 2.72 per cent. Bond bears caution that stronger growth and fears of inflation plus upward hikes in Fed and other interest rates in 2015 could surprise the market and cause bond yields to jump and prices to decline.

On the other hand, Lacy Hunt, economist at Hoisington, a US Treasury fund manager, and Gary Shilling, an independent economist, who have had the best track record on US Treasury bonds for more than two decades, continue to be bullish. Mr Hunt believes that high government, corporate and individual indebtedness reduce direct investment and consumer spending.

The velocity of money, that is turnover of transactions, is thus still in a downward trend and counters the impact of central bank monetary ease. Moreover, the appreciation of the dollar is causing oil, other commodities and US import prices to decline and this in turn pulls down the cost of living, opines Mr Hunt. Short and long-term rates, notably bond yields, could thus remain low or fall further as there is disinflation and deflation in several countries.

"We believe that a 'risk on' investment climate still prevails, despite the many warning signs related to economic growth and financial markets here and abroad," wrote Mr Shilling in a recent edition of his Insights newsletter. "So we continue our defensive stance towards equities and suggest Treasuries as a safe haven and beneficiary of possible deflation, especially in the eurozone, as well as the strengthening dollar."

Mr Shilling doesn't think the long-term rally in Treasuries (going back to 1981 when long-term yields reached 15 per cent) is over yet. He maintains that Treasuries "are the safe haven in the world" and, secondly, inflation is low and "there's real risk of deflation, particularly in Europe". Both Treasuries and the US dollar are also a safe haven against the possibility of a stock-market decline.

Regardless of whether the bond bulls or bears are correct, pension funds and other investors are continuing to buy the securities to keep their portfolios balanced.