Depressed bonds draw investors
DESPITE major losses in the past three years, institutions and retail investors are pouring money into the global bond market.
They are seeking both income and capital gains. The bet of bond bulls is that inflation and interest rates will fall and that the US, European and Asian economies will sag. Such economic and financial circumstances would be ideal for a bond bull market, according to asset managers such as Pimco.
If there is a recession, as several economists predict, sovereign and top-quality investment grade bonds may well outperform equities, property, gold and cash deposits, they say.
Monetary economist Lacy Hunt from Hoisington Investment Management Company, a US treasury bond fund, contends that there is already a recession in the US banking sector. International trade is slipping, so there is a high probability that there will be a US – and potentially global – economic contraction in 2024. In such circumstances, investors will purchase sovereign bonds and avoid more risky corporate debt and equities, Hunt predicts.
Other economists contend that, at worst, the US economy will see a mild slowdown. They point out that the US Federal Reserve Board’s policy is to maintain interest rates at around 5 per cent for a lengthy time. To kill inflation, the Fed also intends keeping money tight at a time when the US Treasury is on a borrowing spree. In these circumstances, the issue of a large supply of US Treasury bonds could well weigh on prices.
The question is whether the severe bond bear market is at last at an end. It began towards the end of 2021 and, despite some rallies, prices have tumbled to new lows. The US is, by far, the world’s biggest bond market with US$53 trillion government and corporate fixed income securities, according to the Bank for International Settlements (BIS).
Singapore, in contrast, has US$656 billion government and company bonds available for investment.
Trillions have thus been lost since 2021. EPFR, a financial data firm, estimates that US bond funds, which invest in sovereign and corporate debt, lost 11 per cent in 2021 and 14 per cent in 2022. Unless there is a major change in trend, 2023 will be another bad year.
These losses need to be put in perspective. They followed a lengthy bond boom that began in 2009 when the Fed and other central banks slashed interest rates and pursued quantitative easing (QE). To achieve QE, central banks bought government bonds from lenders and other institutions. The cash from the sale of the bonds flooded the financial markets and caused a boom in bonds, equities, property and other assets.
The bond boom reached a climax during the pandemic when a combination of spending and a shortage of goods ignited inflation. Central banks raised rates soon after, which in turn caused bond yields to rise and their prices to fall.
The extent of the bond bear market has surprised the investment community. According to the Investment Company Institute, some US$160 billion flowed into US bond funds this year after investors withdrew around US$225 billion in 2022. Rising yields had tempted institutions and retail investors but they incurred capital losses.
A leading example is TLT, a US$39 billion US Treasury exchange traded fund (ETF) run by iShares. TLT plunged from a peak of US$180 in March 2020 to an October 2023 low of US$82 before reviving slightly to current levels of US$85.
Despite accelerated losses since April, investors have placed US$21 billion in TLT in 2023. These investors are taking a serious risk because bonds in the fund have a life of 20 years. The longer the redemption period of the bond, the greater the price fluctuation.
Since mid-2022, the yields on US Treasury bonds with a 20-year life rose from 2 per cent to 5 per cent. The sharp increase caused the price of these bonds to tumble by a whopping 38 per cent. Had investors bought a five-year bond with a similar yield rise, the loss would have been 13 per cent and a three-year bond, 8 per cent.
Bond advisers are cautious and advise investors to buy short-duration bonds to limit potential losses. But if interest rates fall, buyers of TLT or other 20- or 30-year year bonds will enjoy extensive capital appreciation on their investments.
