From this, it is apparent that pricing has become distorted. Investors are now earning 0% (after inflation) when investing in government bonds, while taking the risk of a 50% fall in price. Yet the accepted risk scale would still suggest that this is a ‘low risk’ asset class. A similar situation can be seen in the corporate bond market where the Bank of England is still buying corporate bonds, ostensibly to create liquidity.
A recent example was British American Tobacco, which issued a 2.25% bond for 35 years. This is clearly positive for BAT, but does it make for a good investment? It was substantially over-subscribed, but investors have quickly lost around 20% of their capital since its launch. It shows the vulnerability of longer-dated debt to changes in market sentiment on interest rates and inflation.
Who is still buying at these levels and why? Some have little choice, a number of institutions are required to match liabilities and so provide a natural demand. Equally, the demographic of an ageing population supports pricing as yield is sought. But not enough care is being taken with duration risk and there are real perils to missing this point.
In the immediate aftermath of the Global Financial Crisis, emergency policies were necessary, but this ceased to be appropriate within a couple of years. For capitalism to function properly there needs to be a price discovery mechanism; the market needs to find its own level (just as in any other market). This has not been allowed to happen in this key marketplace, the ‘Bank knows best’.
