What Happened to Bond Yields? – By Daniel Gauci

Ever felt nostalgic looking at pictures of the old days? Sometimes we look at memories and objects that remind us of the past, and we long for times gone by of when things “were better”. These days, local investors may find themselves experiencing a similar form of nostalgia when looking at the previous rate of returns from their investments – in dismay to the returns they get from today’s market. Without a shred of doubt, never as much as today, the lack of income return from investments has been an issue worldwide. This can be confirmed by looking at the historical yield from major indices across the known history. The questions in every investors mind are simple: What has driven this depletion of returns? Is this a temporary situation? Or is it a long-term result of an evolving global economy? These questions and issues keep even the most articulate money managers awake at night, especially those of pension funds – many of which have fallen well behind their investment objectives, who find themselves sitting on a ticking time bomb struggling to generate adequate returns in this world of low to no returns.

Despite marking ten years since the Great Recession of 2008, and ever since global stock markets have well surpassed the heights reach prior to the recession, the situation on the monetary front remains fragile at best in many countries. Central Banks across the globe have refrained from tightening their loose economic policy. The Federal Reserve in the United States is one of a few that have raised interest rates, which currently stands at 2.25%. Interest rate hikes have been slow and gradual in order not to disrupt the economic growth of the past few years. At the current level of rates, the U.S. is still far from the 5.0% levels prior to the Great Recession. Looking at other major central banks, we see that the Euro Zone is still in its final stages of its own version of quantitative easing, and rates are not expected to increase earlier than the end of next year. The expected increases in interest will surely be minor and will only be implemented after the European Central Bank has enough confidence that the underlying economy is showing consistent signs of a sustained recovery. Such view remains an optimistic outlook given the increased uncertainties that the Euro Zone faces – marred by internal challenges and fragmentation.

In this situation, it is clear that all the global central banks would face a substantially bigger challenge should another recession arise. This is mainly because they have little to no interest rate head room upon which to rely on – such would make negative interest rates, whose shadow creeped in the heights of economic uncertainty – a far more realistic outcome. Despite the differing opinions regarding the effectiveness of interest rates, cheap money has definitely played a part in restoring the global economy in the recent years. With hindsight, we can draw the conclusion that central banks have been too accommodative for too long, which in itself has possibly created a debt overhang problem. Debt overhang comes from having excess debt levels in a way that it hampers decision making, and the ability to service debt in the first place. An example of this was recent comments regarding not raising interest rates further in the U.S. as a result of the additional cost.  This would add to servicing a debt which is in excess of $20 trillion.

Another factor which has gone rather unnoticed is the absence of inflation in the recent years. Inflation in the not so distant past used to be a headache for many economies. In itself, inflation is an indicator of demand growth but also a signal of lack of capacity in economies. Investors, in periods of higher inflation, rightly so demanded higher yields to compensate for high inflation levels. As inflation has subdued in the recent years, the premium associated with inflation has eroded. This notion is based on the fact that in periods of lower inflation, the interest received on debt instruments will hold more of their value, and therefore investors demand less compensation for inflationary forces.

During the Great Recession, inflation subdued as a result of deflationary pressures, as consumers cut their consumption in fear of further deterioration in their spending power, and as their livelihoods came under the threat of unemployment.  At a later stage overcapacity in the supply of manufacturing and the labour force ensured that inflation stood at very low levels. In 2011, renewed fears emanating from the European Crisis and the stumbling of global oil prices have ensured that inflation never picked up from its pre-crisis levels. In more recent times, as the economic bell weather has improved, inflation has remained somewhat stagnant. This stagnation can be traced in the overall lack of confidence in the global economy coupled with secular changes in the overall consumption patterns.

Finally, I look to rising global savings as a source of overall decrease in yields. In a pure question of demand and supply, savings levels of households have increased post the Great Recession. This comes on the back of households still remaining relatively conservative compared to pre-crisis levels and the result of increasing income levels and asset values which have in part been pushed by the central banks accommodative policy. Additionally with the advent of globalisation, countries with trade surpluses have invested through sovereign wealth funds in global bonds in a bid to preserve the wealth generated. This effect of increased demand for debt instruments confronted with global corporations sitting on large cash reserves, has systematically created an environment which suppresses bond yields further.

Confronted with this picture, investors can feel intimidated by the prospects of lower yields for longer. Such outlook would require that one becomes smarter in his asset allocation in the objective of generating yield. In the face of the overall increasing volatility, investors today are facing increased risks together with new investment opportunities. From the turn of events during this year, it becomes clearer that volatility is here to stay, after its long hibernation. We can expect that passive investment strategies which have gained momentum in the recent years to make way for active strategies as investing on autopilot, will become a risk that would not be in the best interest of exploiting long-term market trends.

This article was prepared by Daniel Gauci HnD Management, CeFa Investments, anInvestment Advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]; https://www.jesmondmizzi.com