Six Scary Bond Charts!

Investing in government bonds made you a lot of money in recent years. US bond yields were pushed down to unimaginably low levels, but the real bond madness happened in Europe and Japan. German government bonds ‘give’ you a negative return up to 8 years maturity, while Japanese bonds provide negative yields up to 10 years maturity. But it looks increasingly unlikely that this can continue, even as central banks are willing to go to great lengths to realize their goals. Six scary bond charts to underpin this notion.

Long-term view – not so great

From a long-term perspective government bonds are likely to generate dismal returns. Please take a look at the chart from Research Affiliates below (read their insightful article on bond returns here). It shows that the current yield is a very good indication of what your return will be over the next 10 years. A low yield now implies a low return in the coming decade. This is not surprising since buying a bond and holding it until maturity means you ‘lock in’ the current low level of interest.

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Now, any bond bull will tell you that 10 years is a long time and it doesn’t necessarily imply a dismal return in the shorter-term. And they’re right. In the short-term, yields could go even lower. In addition, a steep yield curve is beneficial to your return as you roll down the yield curve over time. No argument there. But the next charts could prove more dominant going forward.

Valuation view – worse

First, government bonds are massively overvalued. The graph below shows the actual German 10-year bond yield and a model estimate that is based on three straightforward data points, the ZEW expectations index, Eurozone core CPI and the 3-month interest rate level. This model, which has a pretty decent track record, suggests the German 10-year should be close to 2.0% and not 0.28%. If everything went back to ‘normal’, which is obviously not the case, the German 10-year bond yield should increase 7-fold, instantly.

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If you think this valuation anomaly is particularly large in Europe, you are wrong. Using a very similar model for the US 10-year Treasury yield, based on the ISM New Orders, US core CPI and US 3-month interest rate, generates an estimate of 3.8%. While the current 10-year yield, at 1.92%, is much higher in the US than in Europe, the rate deviation is also close to 2%. Now there are many factors, (quantitative easing, growth issues, deflation fears, safe haven appetite) that could help explain the valuation gap, but the sheer size of it tells me government bonds are just very expensive.

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Absolute return view – awful

Second, and this does relate more to European bond markets, government bonds offer almost zero protection to rising rates. Take the German 10-year government bond yielding 0.28%. Given the 9.9 years of duration a yield rise of less than 3 basis points is needed to push your return below zero, all things being equal. Imagine the case when you hold a bond which already has a negative yield. You need even lower yields, or large roll returns to make up for that.

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Duration view – risky

Duration itself also plays part. As central banks pushed down yields for you, your duration risk increased along the way. The lower the yield, the higher the duration risk. Any rise in bond yields is likely to exacerbate your losses going forward. Check out the increase in duration of a basket of German and US government bonds in the chart below.

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Last year’s view – scary

The increase in duration risk could be offset if movements in bond yields become smaller over time. But the massive distortion in bond markets, the change in regulation which reduces liquidity and investor positioning make this unlikely in my opinion. Last year’s massive move in the German bond yield seems to confirm this.  The German bond yield rose by almost a full percentage point in just over one month! Hence, be careful when investing in governments bonds.

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