Against the Grain: Rising bond yields – and why regulators should learn to live in the real world

Paul Ormerod
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ARE GOVERNMENT bonds risky? The question arose this time last year, during a meeting with my bank. I wanted a low risk portfolio, but they noted that I did not want to hold UK government bonds. It was not quite clear whether it was the regulator who was insisting, or just the way my bank was interpreting some Delphic pronouncement from the regulator. But I could not be in both categories. Bonds were deemed low risk, so if I wanted to continue not to hold bonds in my portfolio, my risk profile would have to change.

I did not doubt for a moment the financial probity of the British government. It was not about to default on its debt. But at the time, long-dated bonds yielded just under 2 per cent. At some point, the yield would rise, and I would be left with a capital loss on my investment. In the event, yields have indeed recently risen, almost reaching 3 per cent for the ten-year gilt. So a low risk portfolio would have landed me with a nice capital loss of about a third of its initial value. The outcome would have been very similar with US government bonds.

Looking around the world, a year ago there were many opportunities to incur large capital losses by buying government bonds. In Switzerland, the yield on a ten-year bond was just 0.6 per cent but now stands at about 1.1 per cent, implying a capital loss at present of almost 50 per cent. Even in Germany and its economic extensions of Austria and the Netherlands, rates have risen to incur a loss of some 20 per cent on average.

Paradoxically, several economies – where there has been genuine doubt about the financial stability of the government – have generated extremely favourable outcomes for bondholders. In Portugal, yields have fallen from 8.6 per cent to 7.2 per cent over the year, a nice capital gain of 20 per cent. In Spain, the corresponding increase in value has been one third. But the stellar performer is Greece, where anyone willing to buy Greek bonds a year ago would have doubled his or her money.

Of course, all of this comes with the benefit of hindsight, now that everything is clear. But why not? A paper recently published in Nature, one of the top two scientific journals in the world, claimed that a return of 320 per cent could have been made by trading the Dow Jones between 2007 and 2012 using a strategy based on the number of times the word “debt” appeared in the financial press. But both the rule and the trading strategy were all worked out after the event. It is perhaps not surprising that a similar return of 318 per cent could have been made if the words “colour” or “restaurant” had been used instead of debt.

Many regulators seem to inhabit this world of certainty, where everything can be known and someone is at fault if losses are made. The real world is just not like this. A year ago, I was lucky. Maybe I won’t be next time!

Paul Ormerod is an economist at Volterra Partners, a director of the think-tank Synthesis and author of Positive Linking: How Networks Can Revolutionise the World.