The bond-market bloodbath isn’t over yet

The last few weeks have been a “bloodbath” for bond investors, says Rachel Rickard Straus in The Mail on Sunday. Bonds are supposed to offer “a regular, safer income and a ballast against more volatile shares”. It hasn’t worked out that way. Global bond prices, as measured by the Bloomberg Global Aggregate index, are down 10% since the start of the year. Yields, which move inversely to prices, have spiked. “UK investors ditched £2.5bn of bond funds in February alone – the biggest outflow since the start of the pandemic”.

As with so much else, the culprit is rising interest rates. “Bond issuers have to offer something even more enticing to investors than what they could get simply by putting their money in a low-risk, interest-paying account”. Higher yields mean investors who buy into bonds now are getting a better deal, but those who are already holding bonds suffer capital losses. The yield on the US ten-year Treasury bond has risen by more than one percentage point since the start of 2022 to about 2.75%. At the start of the pandemic it traded as low as 0.53%.

A short, sharp cycle

The sell-off isn’t done yet, says Thomas Mathews of Capital Economics. Interest rate rises could push up the ten-year Treasury yield to 3.25% by the end of 2022. Still, “this hiking cycle looks increasingly likely to be a sharp but short one”. Once central banks “stamp out inflation” they may need to reduce rates to support a slowing economy.

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“Bond market pessimism has become so extreme that a rally is a distinct possibility”, says Mark Hulbert for MarketWatch. A few “brave advisers” are asking whether things have gone too far. Their case rests on the argument that central banks may ultimately raise rates less quickly than anticipated. Inflation may have already peaked or be about to do so, and the economy could be heading for recession, both of which would give bonds a boost.

Rising real yields

Rising nominal yields don’t tell the whole story, says John Authers on Bloomberg. With inflation roaring, the “real yield” (ie, yields adjusted for inflation) that investors can expect from bonds has stayed low for most of the past year. Real yields are a better measure of whether financial conditions are actually tighter or not. As measured by ten-year Treasury inflation-protected securities (Tips), real yields in the US had been below zero since March 2020. Yet even that is changing. Last week the ten-year Tips yield briefly crept into positive territory, before falling back again.

Negative real yields have driven much of the risk-taking in markets over the past two years, says Lisa Beilfuss for Barron’s. “A flip in real yields from negative to positive should spur a reversal in some of that yield hunting.” But that may be optimistic, says Jim Reid of Deutsche Bank. On current inflation, ten-year Treasuries are yielding -5.6%. The Tips yield is ticking higher only because investors expect inflation to fall in the next few years. “I’m still not convinced inflation falls anywhere near enough over the next couple of years for real yields to get anywhere near positive… If I’m wrong… run for the hills given the global debt pile.”

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