Historically Low Bond Yields!

The main weapon, and the one that Central banks are most comfortable with, was to use low interest rates in the battle to regain stability following the financial crisis.  However, the level of interest rates that is most appropriate is dependent on other factors too such as demand and supply, inflation, period of investment and the level of risk being taken. 

One of the safest investments, before the crisis, was to lend to governments because they were expected to always be able to repay the investor at maturity, whilst lending to companies is perceived to be less safe. The reward or interest rate paid for holding government stock was lower than that gained from holding company bonds before the crisis but reversed when investors feared that their investments in some government stock was now in doubt. Blue chip companies, on the other hand, were perceived as remaining relatively safe. The reward for holding company stock became lower than that demanded for holding some government stock such as that issued by Greece, Italy, Ireland, Portugal and Spain although they are part of the European community.

Central Banks brought the benchmark interest rates down to very low levels in the early stages of the crisis, leaving investors with funds in cash savings earning a very low return on their money. Slowly these investors realised that interest rates would stay low for a long time and some moved their investment profile into higher risk investments where better returns could be achieved.  The less sophisticated investors utilised collective investment vehicles to get the better returns that they needed while the professionals judged that the protection of central Banks may justify investing some portion of their assets into the very high yielding stock such as that issued by the PIIGS countries who were, after all, protected by the ECB.  Whilst this analysis was in doubt for a very long time as the politicians sought to increase the controls over the peripheral countries’ finances with implied threats of removing that protection unless they fell into line, it has proved a great success for these early investors with high yields and capital returns.  

The increase in liquidity created by the central banks of America and United Kingdom had to find a home and income became the main target for these funds.  This was found, not only, in the bonds issued for the debts of the PIIGS but also in the debt of emerging markets.  Issuance in these areas is relatively low and the huge level of funds chasing yield soon pushed prices up and yields down but in many cases yields remained higher than that obtained in the main bond markets in the US, UK and Germany.  The gradual subsidence of fear in the market added to the attractions of these relatively high risk but higher yielding investments.

Most investors in the bond market are and remain the institutions that need to match their liabilities with their assets because they need to ‘know’ that they will have the funds to match the liability when it arises.  These funds will continue to buy bonds with the right maturity and can, at present, justify the low yields by ensuring that they are higher than the low level that inflation is or than cash returns.  The other funds that buy these bonds are those of collective funds who are satisfying the needs of the retail investor for a return that is better than that obtained from cash.

Prices and yields traditionally move in opposite directions with interest rates being the key driver of short term bonds which would be expected to rise along with key interest rates, whereas long term bonds are more affected by inflation expectations and economic growth. If inflation is expected to rise and economies are growing the yields of longer term bonds will rise and prices will fall.

Short term bonds will be impacted by the shape of the yield curve which is a graphical representation of the yields that are currently available at the various maturities.  It is based on the idea that there is a connection between a bond’s maturity date and yield.  Historically shorter term bonds have offered lower yields while long term bonds would produce higher yields so a “normal” yield curve would begin in the bottom left of the graph and arc up towards the top right of the graph.

The ECB bank rate is in the bottom left hand corner at zero which causes all other short term rates to be dragged towards it.  Inverted yield curves have been indicators of a slowdown in economic growth, low inflation and further expectations of interest rate cuts.

The financial crisis has led to a period of low inflation expectations and central bank rates so that yields are low from the short dated bonds through to the long dated issuances.  The demand for yield has resulted in the issuance of more long dated bonds which gives the investor the advantage of covering longer dated liabilities and of giving a higher level of income.

Liquidity has remained in the hands of corporates and retail investors and their demand for low risk yield has created the funds to meet the supply of funds from governments.  The slow rate of growth in profits and weak retail and business demand for goods and services has perpetuated this very low yield environment. The policy being followed, however, is designed to reverse this situation and when it does yields will return to more normal levels.  The US is reining back on this accommodative stance and the UK has already stopped fuelling liquidity with more funds.  In Europe the ECB still has more to do to combat deflation and increase growth so we may expect to see yields rising in the US and UK over the medium term but remain low in Europe.  Subject to inflation remaining low across these areas this should increase the attractions of the US Dollar and Pound when compared with the Euro.