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Are government bonds too expensive?

Jake Cordell
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Daniel Craig as James Bond holding gun
German investors would like to see 007 popping up on their short-term government bonds (Source: Getty)

Government bond yields could have passed their nadir, investment banks and bond analysts have suggested, with borrowing costs rising and the outlook for major economies in flux.

As the US Federal Reserve has hesitated on raising rates, the Brexit vote threw the financial markets into brief turmoil and the Eurozone has shown only tentative signs of returning to an era of growth and inflation, the scramble for government bonds as a safe haven pushed yields across the world to their lowest level on record.

But, a number of analysts think that period could be coming to an end, and some investment houses are moving their money around in anticipation we could have passed bond prices.

Bonds: Yields, prices, coupons and maturities

Bond prices and yields move in opposite directions.

Because most debt is worth a fixed sum and pays a fixed amount of interest for a fixed amount of time, investors know exactly how much they will be getting back over the course of the bond’s lifetime and the buying and selling takes place in terms of today’s price.

For instance, a company or government issues a £100m bond with a one-year maturity which they will pay one per cent interest on. The investors are set to receive £101m back one year later. If they pay £100m for the £100m bond, this is a yield of one per cent.

However, if demand is strong for any number of reasons, they might pay £101m for the £101m return one year later, an effective yield of zero.

The question of whether the price or the yield is more important depends on the kind of investor you are. Long-term vehicles such as pension funds, which hold bonds until they mature, are being hit by lower yields since they can’t generate returns as they are locked in to whatever the yield was when they purchased the bond.

Meanwhile, shorter-term investors, or fund managers that move in and out of assets more regularly, win when the price rises since they can sell and move into other products, such as equities, cash or commodities if they see better potential for returns.

Yields on UK debt have already begun to creep up. The return on benchmark 10-year debt hit a record low of 0.52 per cent on 12 August, one week after the Bank of England announced its post-referendum stimulus package. This afternoon they have recovered to 0.83 per cent - still down from 1.82 per cent a year ago.

In the United States the 10-year treasury bond returns 1.68 per cent, up from its record low of 1.46 per cent hit in both late June and late July.

Outflows from funds which focus on US investment grade corporate debt, which generally moves in tandem with government borrowing costs, have hit their highest level in nine months, Deutsche Bank noted this morning, as shorter-term investors book profits.

Read more: Will Mark Carney's corporate bond buying help UK companies?

Societe Generale and JP Morgan Asset Management are two of the investment teams that have advised clients to shift out of government bonds, believing their prices - and therefore the paper value of portfolios - are set to come down.

Sovereign bonds… appear expensive. The asset class might not offer good portfolio protection as in the past,” Societe Generale stated in a quarterly investment strategy update for its clients.

Societe Generale believes 10-year bond yields are set to climb over the next 18 months.

JP Morgan’s head of multi-asset strategy John Bilton said plainly: “We see stocks modestly outperforming government bonds” in the future.

Larry Hatheway at GAM, a Swiss asset management outfit, explained the dynamics at play in the bond market at the moment: “In spite of the recent softness in US economic indicators, market participants have increased the odds of a further Fed rate hike in December to roughly 50 per cent, compared with much lower levels immediately following the outcome of the UK referendum.

“Second, doubts have emerged about whether the Bank of Japan, the European Central Bank or the Bank of England will ease further.”

Read more: The Bank of England's corporate bond-buying unveiled

With uncertainty over the future of interest rates, many are tentatively pricing in rising yields over the coming years.

Societe Generale expects the borrowing costs on 10-year government debt in the US to rise from 1.7 to 2.2 per cent over the next two years. In the UK, it believes yields will go back above one per cent within a year, and Germany should put an end to its flirtation with negative yields on 10-year debt by the beginning of next year.

However, the top of the bond market has been called before and with the Bank of England and European Central Bank extending their money-printing quantitative easing programmes into the corporate world, this is uncharted territory for many traders.

Read more: The two banks betting on a US interest rate rise

Jim Leaviss, of M&G Investments, part of the Prudential group, warned in a report this morning that the bond market dynamics just aren’t what they used to be.

“For much of the 20th century, understanding the demographic changes in the western world would have allowed you to predict government bond yields pretty accurately,” he said.

“In the past few years, however, those old models have completely stopped working.”

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