The Worrying Weak Point for Super-Strong Bonds
Rising inflation expectations, monetary policy uncertainty not the only reasons for concern
By Richard Barley
For Superman, it was kryptonite. For bonds, the weak point is more insidious: it is precisely their previous superstrong performance that makes them unusually vulnerable.
Bonds are having a rough time. In the U.S. and Germany, 10-year yields have hit their highest level since May. U.K. yields have doubled in a month. The fundamental reasons to worry about bonds are rising inflation expectations and greater uncertainty about future monetary policy.
But there is also a powerful technical reason to consider. The greatest risk lies in bonds that had ascended to the dizziest heights. That helps explain why this week, for instance, 10-year yields have risen more sharply in Germany and the U.K. than the U.S., even though that might look odd when it is the U.S. Federal Reserve that is thinking about raising rates, while the European Central Bank and Bank of England are engaged in quantitative easing.
The problem is clearest in Germany. Normally, a selloff in bonds would be cushioned by a constant stream of income from the regular interest payments they produce. But in Germany, thanks to the rally that drove yields lower throughout the first half of this year, the 10-year bond pays no coupon. That means its price is ultrasensitive to movements in yields. In bond-market jargon, it has a high duration.
The features of the ECB’s bond-purchase program exacerbate this problem. As long as yields were falling, more and more bonds were becoming ineligible for purchase, since they yielded less than the ECB deposit rate of minus 0.4%. But a selloff reverses that process and creates problems: the more shorter-maturity bonds qualify for ECB purchase, the less support there is for longer-dated bonds.
And at really long maturities, the picture is even more extreme. Just take a look at Austria’s 70-year bond, sold earlier this week. The yield has risen around 0.1 percentage point since it was sold on Tuesday—but the price has fallen by around 4.5%.
There is an anti-kryptonite for the bond market: the search for yield. This force is likely to remain powerful, since it is in part driven by financial regulation, although inflation will challenge it. New issues with higher yields will probably prove attractive. But today’s bonds, where the yield has been squeezed out of them already, reducing their defensive qualities, are facing tough times. Even superheroes can’t fly forever.