Markets Insight
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March 26, 2012 11:11 am
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Investors must not be cowed by end of bond run
.Investors must not be cowed by end of bond run
Powerful new dynamics are shaping the US bond market in ways that will require many investors to fundamentally rethink their portfolios. Chief among these is a shrinking supply of fixed income assets and a ravenous investor appetite for yield, which will combine to keep interest rates lower for much longer than most people expect.
We have all heard the bears’ case for bonds: with governments and consumers in the developed world drowning in debt and negative real interest rates on many sovereign bonds, yields can only rise – quickly.
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Not so fast: The confluence of profound supply and demand factors, with a dash of monetary policy distortion thrown in, will ensure bonds remain well-bid – and interest rates capped – for years to come.
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On the supply side of the equation, investors are confronting a US bond market that has shrunk since the financial crisis and is likely to keep shrinking. Why?
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A big reason is the contraction in financial industry bond issuance. Globally, banks are deleveraging in the wake of the financial crisis and subsequent regulatory push to pare down risk. US financial institutions alone will reduce their debt by $360bn this year. Even the supply of US Treasuries is expected to decline.
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Gross US Treasury issuance in 2013 could be $1.9tn, according to Credit Suisse research, down 17 per cent from 2010 levels. And with the Federal Reserve purchasing Treasury bonds, net supply looks even more constrained.
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For investors with high quality investment mandates, the supply challenge may be even greater. Downgrades of US and French government debt by Standard & Poor’s have cut the agency’s triple A sovereign universe by more than half. At the same time, investors have never been hungrier for yield.
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Public and private pensions are underfunded and face negative real rates on many traditionally core bond holdings. Most personal savings and retirement accounts will not be able to finance their owners’ increasingly long retirements, especially after some $8.7tn in wealth evaporated after the 2006 peak of the US housing market.
As a result, many companies are topping up their pension plan assets and shifting their allocation mix to fixed income to match their liabilities better. BlackRock expects US corporate pensions will put nearly $1.2tn into long-term bond strategies over the coming decade. US insurance companies may buy $600bn of bonds this year alone.
Compounding these trends are the significant market distortions resulting from monetary policy. The Fed’s near-zero interest rate policy, rounds of quantitative easing and Operation Twist have pressured yields – and the yield curve – lower than they naturally would be.
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While these policies have boosted equities and other risk assets by forcing investors to search for higher yields and returns, there are risks. These include the potential for future inflation and of policy distortions temporarily masking deeper structural problems in the global economy.
As a result, we think yields on 10-year Treasuries could drift higher, to the mid-to-high 2 per cent range by year-end, from about 2 per cent at present. What does all this add up to?
First, the only “bubble” in the bond market appears to be the overinflated talk of bond market bubbles in recent years. All signs point to bonds remaining well-bid, even if rates rise modestly. We simply do not see a bear market on the horizon that would force investors away from bond markets.
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Second, as credit risk creeps into the government bond sector, investors should increasingly look to corporate bonds when seeking safety and yield. Corporations have worked diligently to improve their balance sheets in recent years and fundamentals on corporate credits are as good as they have ever been. That’s not to suggest that we won’t see some volatility in credit spreads. A few defaults could still stir markets from time-to-time, but the sector looks strong overall.
Finally, given low yields and limited potential for price appreciation, US Treasuries should not be a primary source of yield in most portfolios. The best opportunities exist in assets such as high yield and investment-grade corporate credits as well as certain asset-backed securities.
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The 30-year bull market for bonds, which saw long-term Treasury yields decline from the mid-teens in the early 1980s, is over. But rates won’t spike dramatically soon. Shrinking supply, high demand and ultra-loose monetary policies will conspire to keep a tight lid on yields. For investors starved of yield, this much is clear: a new playbook is needed for success in fixed income. Understanding these new market dynamics and risks is a place to start.
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Rick Rieder is BlackRock’s Chief Investment Officer of Fixed Income, Fundamental Portfolios
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