One of the longest bull-runs in history is coming to an end…
Bonds have been on a bull-run for 30+ years. In the 1980s, the US was battling with high inflation. To combat this, the Feds raised interest rates which reduced consumer spending (as borrowing costs became higher). So demand for goods went down causing inflation to drop by 12%.
As the US curbed inflation, they slowly dropped interest rates. The more interest rates dropped, the higher bond prices went (Many countries are sitting with low or negative interest rates today).
Also keep in mind, bond prices and bond yields move in opposite directions. So as prices were increasing, yields were decreasing. And since the 1980s, yields have dropped to lows of +-1%.
US Treasury 10-year bond yields 1.8% (with 0.5% interest rate)
German 10-year bond yields just 0.06% (with 0% interest rate)
Japan 10-year bond yield -0.06% (with a -0.1% interest rate)
So why would people invest for low yields?
Well, buying government debt is similar to paying government to guard your cash in a vault. But government debt is liquid – It can be bought and sold quickly at little cost.
Investors need returns, but they must also balance this with a need for liquidity, which bonds provide.
What’s more, this year global equity markets have been hit thanks to Brexit fears and low global economic growth. This has encouraged investors to shift more of their portfolios into safe haven assets like bonds driving bond prices high and yields extremely low.
But as I said, when investors pile into an asset, a bubble forms and prices become unsustainable.
What really is the bond “bubble”?
The theory behind the coming bond “bubble” is this: Treasury bond yields have dropped so low that there’s no room for yields to fall further.
What’s more, low bond yields are a result of low interest rate policies. Once economies fully recover, the thinking goes, interest rates will slowly rise. And when this finally occurs, downward pressure on Treasury yields will be removed, and yields will rise sharply, as bond prices fall (bubble pops).
Thirdly, as I mentioned earlier, before a bubble pops, investors will start a massive sell-off.
Well in September, the number of US Treasury bonds held declined by over $27.5 billion in one week - The biggest weekly drop since January 2015.
One month later, foreign central banks like China and Saudi Arabia continued selling US Treasuries, which fell another $22.3 billion. Again this is another sign that bond prices have become too high and that an even bigger sell-off is imminent.
So what should you do to protect yourself as a South African investor?
Although developed market government bonds offer protection, it’s important to consider what price you are paying for that protection.
If you pay a high price and the bond market crashes, then you’ll lose your entire investment.
What’s more, if the bond market falls, stocks will most likely fall with it, as investors flee to safe haven assets like gold and silver.
As you know in times of extreme volatility, gold and silver triumph.
But if you look at South African government bonds, they offer an attractive yield compared to developed markets. A major panic would have to occur for our bonds to crash.
But consider this:
US Treasury 10-year bond offers a yield of around 1.8%. Factor in US inflation of 1.5% and you’re essentially receiving a 0.3% yield.
South Africa’s 10-year government bond offers a yield around 8.6%.
Factor in 6% inflation and you’re receiving a yield of around 2.6%, which is quite attractive compared to offshore bonds.
But as with every investment, always make sure you know the risks. If South Africa gets downgraded, then our bonds may crash.
And if the bond market does crash, always remember to place a stop loss to protect your portfolio.
Until next time,
Joshua Benton, Real Wealth