‘Juiced out’ bonds pushing money elsewhere?

[LONDON] The market mood of the moment is whether bubbles are being blown in riskier markets by loose fiscal and monetary policies that lift the inflation horizon for years to come. Still, compressed yields in gigantic global debt markets may give a glimpse of what’s happening.

With mounting fears for central bank independence from Washington to Tokyo and little appetite anywhere for unpopular budget cutting, the prospect of inflation rates returning sustainably back to longstanding 2 per cent targets has dimmed.

That does not even have to mean another bout of runaway post-pandemic inflation, but it could trigger 3 to 4 per cent inflation for the world’s major economies to start to get baked in. Already, core inflation for the Group of Seven economies as a whole is settling at 3 per cent.

That may underpin nominal gross domestic product growth and record-high equities – goosing high-octane bets in tech, artificial intelligence, private markets and even gold in the process. But it is a sour prospect for the already-clipped returns in global government and corporate fixed income that still house the lion’s share of investment capital.

Apollo’s chief economist Torsten Slok pointed out late last week that almost 90 per cent of all public fixed income outstanding now trades with a yield of under 5 per cent. With inflation running at 3 per cent, that leaves a real return of just 2 per cent.

It is a big universe of relatively meagre long-term returns.

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The latest annual data from the Securities Industry and Financial Markets Association indicates that global fixed income outstanding hit US$145.1 trillion through last year – up 75 per cent in the past decade and still bigger than the entire global equity market capitalisation of US$126.7 trillion.

Of course, big players in the private credit market such as Apollo may have good reason to highlight the dearth of return in public markets; it is one of the big arguments for channelling investors into the less transparent, but typically higher-yielding private credit space.

What’s more, there are a host of reasons why investors hold government and public bonds at large: capital preservation for central banks, sovereign and pension funds, regulatory and liquidity demands for banks and insurers and steady long-term income in mixed portfolios.

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But the marginal real return arguments may see more bond capital leak elsewhere if higher inflation is indeed now entrenched.

Even that private credit universe, while growing rapidly, is still only about US$2 trillion in total size and the market cap of physical gold is a relatively modest US$26 trillion. While tech stock market cap has ballooned over the past 10 years, it is concentrated in a relatively small number of mega firms.

So, relatively small portfolio shifts from the bond universe may have outsize impacts in these areas.

Managing idiosyncracies

Fixed-income fund managers talk of generating better returns through active management: playing yield curves, spread trades, selective company names and even riskier bets that enhance those returns as long as economic growth holds up.

While not seen as a major worry yet, recent jitters about credit accidents in the private debt world – surrounding the First Brands bust in particular – and creeping high-yield defaults may add headaches.

BlackRock’s credit team insists some of the jolts in credit are “idiosyncratic”, and that the peak in recent default activity is likely behind us; it remains positive on corporate credit as interest rates fall and growth continues.

But it has been hard station for aggregate bond holdings in recent years in any event.

The Bloomberg Multiverse of all global bonds is currently yielding 3.7 per cent, with the government component just 3.2 per cent – leaving the real yield on the latter barely positive. To be sure, that is marginally better than the negative real yields of much of the past decade, but it is still two percentage points below levels before the credit crash of 2007/2008.

Average annual total returns on that government index over the past decade have been about 0.5 per cent.

Most risk-averse investors who hold these bonds may not be in them for relative yield. But a higher inflation world makes them more uncomfortable as a safety hedge – and even edging away may supercharge everything else. REUTERS