The first was the decline in yields in the core government bond markets such as the US, the UK, Sweden and Germany.
The second was the widening of credit spreads in parts of the bond market most vulnerable to the two huge macro themes of sovereign and bank balance sheet deterioration.
Credit risk key
These two drivers generated a significant variation in performance across bond markets – ranging from the -59% total return on a calendar year basis from Greek government bonds to the 21% total return from UK index-linked bonds. The best performing parts of the market were those assets that had little credit risk (either real or perceived) and long duration, while the worst performing were the parts of the market where credit risk became most stressed.
In the middle, the opposing forces of lower risk-free yields and generally worse credit risk fought it out.
For example, although the spread on the UK investment grade credit index rose by 126 basis points over the course of 2011, the total return from this asset class was a very respectable 7.0%.
The motivation to buy long duration assets is coming from the view that global interest rates will remain at their historically low levels for an extended period of time because of the weakness of global growth. The most favoured long duration assets are those highly rated ones in countries either outside of the eurozone (US Treasuries, UK gilts, Australian and New Zealand governments), those that have some inflation protection (US and UK index-linked bonds) and, within the eurozone, Germany (for those investors that have to have euro assets but don’t want exposure to most of the European sovereigns).
The pricing out of any interest rate risk for the next two to three years has left short to medium-term bond yields extremely low and yield curve spreads relatively high.
Low yields
This does seem rational at the moment, at least for the short term. The stance of the major central banks is clear. The Federal Reserve has stated that it is likely to keep interest rates unchanged until 2013 and at its recent FOMC meeting agreed to publish the interest rate forecasts of individual members.
This is the latest in a series of steps to increase the transparency of monetary policy and to anchor even more strongly the medium term expectations on rates. The result is that market yields on all Treasury securities with a remaining maturity of up to ten years are less than 2% and up to five years are less than 1%. It is not too different for the UK and Germany, while yields on all maturities out to 30 years are below 2% in Japan.
These government bond markets are pricing in an unprecedented period of low rates. The implication of this is a very gloomy economic growth outlook. Indeed, the forward curve for the US implies that three-month interest rates will still be less than 3% in ten years time (in the UK the corresponding three month to ten year forward rate is 3.05% and in Germany it is 2.6%).
The longevity of this macro-economic scenario is based on the assessment of how long it will take to deal with the build-up in debt experienced over the past 20 years or so. Investors have been left in no doubt how difficult it is for governments to stabilise their debt ratios. Banks are finding it very difficult to obtain private funding for their balance sheets and will have little choice but to reduce assets under the pressure of higher capital ratios and more expensive funding going forward. Households are de-leveraging as well, but it takes a long time to bring debt/income levels down to more sustainable levels in a world where income is not growing strongly.
The pressure on all economic agents with high debt is to reduce spending. This, in aggregate, means very low growth.
