Has the countdown begun for bond Armageddon?

By Clive Hale, director, FundCalibre

Added 17th June 2016

Last week, Janus Capital's Bill Gross, a fixed income manager whose views I greatly respect, Tweeted the following: “Global yields lowest in 500 years of recorded history. $10 trillion of neg. rate bonds. This is a supernova that will explode one day.”

Has the countdown begun for bond Armageddon?

Now, when UK government bond yields were at 4%, he also said that gilts were sitting on a bed of nitroglycerine! So he isnt always right. But I'm with him on this one.

In his latest investment outlook, Gross observes that the 40-year bull market's 7.5% historical returns are just that – history. In order to duplicate that number, yields would have to drop to -17%! So a repeat performance in our lifetime is not only unlikely, it is impossible.

Duration, as he says, is a risk in negative yielding markets, which is why so many bond fund managers are underweight duration at the moment. As an example, just a minus 0.25% yield on a 5-year German Bund results in inevitable losses in 5 years' time. Some investors seem to have lost control of their senses and are willing to buy these bonds, in the knowledge they will lose some of their capital, but if rates go any lower, even these mad people may reconsider.

Further up the credit scale and the risk/reward scenario is little better. The spread of a 5-year investment grade bond over the next year is a mere 25 basis points, according to Gross. So you are hardly being paid for taking the extra risk. I suppose you are at least being paid though, as apposed to being charged!

The trouble is, if you are chasing higher yields, you either need to go into long and longer-dated bonds, or much further up the risk scale. High yield bonds are still priced like equities and will probably behave like them when the markets take flight.

Super Mario started flashing his corporate credit card earlier this month, with his circa €80bn* monthly bond shopping list. He is effectively extending the bond buying cycle, but this doesn't mean the inevitable reversal is no longer a concern.

We have been saying for some time now that bond yields can’t go any lower. Still they persist, but for how long? Could a potential Brexit outcome on June 24th be the catalyst for a bond Armageddon?

Certainly the Fed is worried. Whilst the UK represents less than 3% of the global economy, Janet Yellen all but said yesterday that they were awaiting the outcome of the referendum before the world's largest economy makes the next move on interest rates.

If Brexit isn't the trigger, it has to be just a matter of time before the inevitable happens though, surely? Or are we headed for the Japan experience: low rates forever?

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Clive’s views are his own and do not constitute financial advice. *Government and investment grade bonds. The exact amount used to purchase investment grade bonds is estimated to be around €5–10bn.

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