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How can we extract value from bond markets?

According to Pascal Gilbert, Head of Fixed Income, La Française, Bond markets are facing historically low yields, and this ongoing situation leaves, in theory, little room for a further appreciation in bond prices.

At a fundamental level, if we compare bond returns to the growth and expected inflation outlook over the same period, we also reach record lows. Actual returns on the safest bonds – for example those of the German, British, Swiss, Swedish governments (and others) – are highly negative, implying the certain loss of purchasing power for long-term investors.

Will this situation, unprecedented in the modern history of financial markets, lead to negative performance for bond investors after three decades when it was not unusual to record double-digit capital gains? For the time being, even if few investors have turned away from the asset class, many are unsure of what to do. The case of Japan does however, offer an interesting example.

Since the beginning of the millennium, i.e. over the last 17 years, Japanese bond rates have remained low. Yet, with the exception of 2003, bond investors’ yearly performance has always been positive.

Today these results, which may seem counter-intuitive, should represent hope for bond investors. We must fully understand what happened in Japan and the driving forces behind the market. The first striking feature is the low volatility of long-term rates, which has multiple causes.

It is disproportionately low relative to what is observed in other countries. There was never any expectation of a tightening of monetary policy. Therefore, without volatility (and without the hope of tomorrow getting a rate of return that is substantially higher than the one offered today) it is imperative to invest when the yield curve is positive. In short, the slope of the yield curve reflects the volatility of long-term rates. It expresses “the value of time”, with the price varying in relation to the volatility of interest rates.

Our calculations have enabled us to prioritise the 3-year and above maturities yield curve, which also corresponds to the average length of central banks’ conventional monetary policy cycles. In several developed countries, the same causes behind the lower volatility of long-term Japanese rates, are gradually beginning to surface (weaker economic growth, an ageing population…) which could limit inflation prospects.

This downward trend in the volatility of fixed-income assets is only beginning. It represents a strong foundation for the government bond market. This inevitable decline will not be linear, and will probably be interrupted by short periods of increased stress. These periods of increased yields, occurring around increased volatility, represent investment opportunities conducive to potential performance.

Changes in this risk-return profile, built on the shape of the yield curve and the volatility of the relevant asset, are historically stable. Moreover, its magnitude is common to all government bonds presenting the same essential characteristics: very high creditworthiness and a credible central bank, which generally go hand-in-hand!

Lastly, the same type of analysis can be applied to corporate bonds in the private sector. However, such an analysis is more complex, as it must take into consideration two aspects that are not relevant to most sovereign bonds: the risks of illiquidity and of default. These last two parameters can however express themselves easily through our initial indicators: the risk of default can be modelled as a depreciator of the expected yield, and that of illiquidity as an excess of volatility to be absorbed. This simplifies the equation involving corporate debt which can therefore be compared to other fixed-income assets. In conclusion, we don’t believe the challenge is to know whether there is still value in bond markets, but rather to know how to extract it.

Pascal Gilbert , May 5

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