How much yield is enough? Responding to a shift in the global bond landscape

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 12 O c t o b e r V o l u m e 9 79 How much yield is enough? Responding to a shift in the global bond landscape Written by: Denzil Burger, Portfolio Manager at Old Mutual MacroSolutions Most participants in the investment markets, apart from those who only recently started out, have effectively experienced a broad bull market in global bonds throughout their working life. Yields on long-term US government bonds peaked in the mid-teens in the early 1980s after US Federal Reserve Chairman Paul Volcker begun implementing painful and unpopular adjustment measures to address the high rate of inflation which had crept up from 1% in 1965 to 14% in These measures saw bond yields in the US and globally trend down (yields fall and bond prices rise) as inflation pressures eased back towards low single digits. Further downward pressure on yields was experienced during the Great Financial Crisis and beyond when the US Federal Reserve (Fed) again played a very active role, including more direct intervention in the investment markets through the purchasing of debt instruments to avoid the world plunging into a depression by engineering a relatively soft landing. Through much of the past seven years, the yield on the US 10-year government bond, which acts as an important global benchmark for the pricing of longterm debt, has whipsawed around the 2% level. Many wondered if we would ever see a 3% yield from these bonds again. Page 1

2 LIFE BEYOND THE BULL The long-running bond bull market appears to now finally be over, with the US yield having doubled from under 1.5% just two years ago, although other developed bond markets are struggling to make the same move away from historically still very low levels (see graph). For a long time, we have been negative on global bonds, as we have been of the view that interest rates would need to begin normalising (i.e. rise) as economic growth continued to recover in the US and across the world. While 3% has no relevance as a level in itself (we humans tend to attach significance to round numbers), it feels appropriate at this point to revisit the merits or otherwise of this asset class with a view to avoiding it becoming a potential blind spot: Could there be value in including global or US bonds in investment portfolios and at what price? DEVELOPED MARKET BOND YIELDS HAVE TROUGHED (AUGUST JULY 2018) Source: FactSet WHEN THE PRICE IS RIGHT In re-evaluating our negative normalisation theme we could ask ourselves: What yield would be a normal or fair level? It is broadly accepted that interest rates should tend towards the natural rate of growth of the economy over time. Any higher and it tends to be restrictive to economic activity, while if it lags significantly lower there is increased risk of excesses developing, as financing costs become too cheap. The graph on the following page shows the nominal growth rate of the US economy over the long term smoothed over rolling 12-quarter (three-year) periods. Page 2

3 As can be seen, the 10-year yield follows the broad trend of underlying nominal economic activity, although it can deviate for significant periods depending on policy and other factors. The yield has traded below the nominal growth rate for several years now, and while that is not uncommon, sustained higher nominal economic growth could see further upward pressure on the yield. Inflation is a significant part of the picture and a pick up in the rate, together with better real growth, has seen much higher nominal growth experienced in the US recently. We know that the US Fed is in the process of hiking official rates in the face of relatively strong growth with low unemployment and is likely to continue until policy is sufficiently restrictive to manage inflation risks. This could well put a cap on the upside potential for yields below the 4%+ level that the graph might imply. LONG BOND YIELD BROADLY TRACKS ECONOMIC GROWTH (OCTOBER JUNE 2018) Source: FactSet On balance, though, we would still expect yields to move higher from current levels. The sensitivity of bond pricing is such that a third of a percent increase in the yield of the 10-year bond would effectively wipe out the interest earned over a year. This works both ways, of course, and buying can be tactically rewarding. Why the interest in global or US bonds from a South African investor perspective? Clearly, the US long bond yield serves as a benchmark rate for much of the pricing of debt and asset classes around the world, including South Africa. Rising US yields reduces the relative attraction of South African assets and puts upward pressure on our yields, all else being equal. This aspect is incorporated in the ongoing assessment of our investment themes and asset class pricing and is not explored further in this piece. Page 3

4 From a portfolio construction perspective, global bonds can be beneficial from an investment return point of view if bought at the right price. While it is difficult to be enthusiastic about buying assets that yield a mere 3-4% p.a., and less in the developed markets outside of the US, this needs to be seen against the fairly expensive rating of other asset classes. Further, weakness in the rand would boost returns in local currency terms. Global bonds can also be a very valuable addition in managing the risk of a portfolio. Historical data confirms the diversification benefit of holding some exposure to global bonds. The surprise further relaxation earlier this year of the limit to offshore assets that may be held in local institutional investment portfolios led us to revisit the holdings that serve as long-term strategic benchmarks for our portfolios. Given the increased global capacity, the conclusion from our analysis was that the appropriate exposure to global bonds, from a long-term strategic point of view, increased to 7.5% for a balanced fund. While we do not think it is appropriate to move to anywhere near that level at this point, it is becoming increasingly fitting to raise our attention to this asset class. Page 4

5 Glacier Research would like to thank Denzil Burger for his contribution to this week s Funds on Friday. Denzil Burger Bcom Denzil is part of the MacroSolutions boutique within Old Mutual Investment Group. He was appointed as portfolio manager for the investment strategy of the OMLAC(SA) portfolios (Life funds) in October He has been actively involved in asset allocation since the inception of the previous named Old Mutual Asset Management (OMAM) Asset Allocation Group in He continues to play an active role in the management of MacroSolutions' institutional international portfolios and is specifically responsible for the World Balanced Funds. Denzil joined Old Mutual in 1983, and has held a number of different positions in the investment area. His broad experience has given him a wealth of knowledge across a wide range of investment matters, with one of his responsibilities having been the coordination of asset swap activity. Denzil managed the optimised portfolios of the Fairbairn Capital range and the PP Select Life portfolios since inception until September He has also managed pooled and segregated portfolios for SA and Namibian clients for many years. Page 5