The decline in global bond yields
Author, Bill Prendergast.
Much to the frustration of savers, the last 35 years has seen a dramatic decline in bond yields in most of the major economies. This has been a global phenomenon rather than being isolated to one or two major economies. While the drivers of this have been varied (demographics, regulation, lower inflation due to technology and China’s increasing impact on the global economy, and more recently the post Global Financial Crisis quantitative easing policies), it is necessary to understand the impact this has on the requirement to meet income objectives from an investment portfolio.
It is generally thought that lower yields encourage risk-taking, which along with the impact of lowering borrowing costs and thereby stimulating economic activity, is seen as the rationale for using monetary policy to manage the economy. Clearly in the post GFC era, massive stimulation has been injected into the global economy by central banks (led by the US Federal Reserve, the Bank of Japan, the European Central Bank, and the Bank of England) and this has had the effect of pushing up asset prices (most notably equities, property and some precious metals), and holding yields on the bond market at all-time lows. The Reserve Bank of Australia is clearly caught in this global process, with rates at record lows and for an extended period of time, without having the usual impact on a tepid economy, albeit one buffeted by declining demand for our export commodities. The concern for central banks at this stage is there has not been a strong impact on activity and perhaps even more concerning, an impact on inflation. Inflation continues to hold well below the desired levels or targets of major central banks, and there is a view following Japan’s move into zero rates in the late 1990s that inflation cannot be created at will by central banks. This is very different from the views held in the 1970s and 1980s where arguably, monetary policy was used effectively to manage inflation. Markets are pricing in a sustained period of very low inflation despite this liquidity.
Extremely low interest rates also have the effect of dampening volatility in financial markets, and although as we have seen recently, markets are aware that at some point suppressed volatility will likely be replaced by flare-ups and losses of capital.
What are the implications for investing?
The key learning from many years of low rates, is not to be encouraged to take more risk than an investor can bear. A sharp move lower in bond prices or equity markets will wipe out more than the additional yield earned from a slightly higher-yielding investment. This is also relevant in the demand for higher yielding stocks – it is critical to understand the drivers of a stock (or corporate bond) rather than simply the current yield. BHP is a standout example in Australia. The company has made a point of its progressive dividend policy (ie increasing the dividend every year), but this has not helped from an overall investment perspective as the balance sheet has deteriorated and the stock has been driven lower by volatility in commodity markets. Telstra is another stock which performed very well in the low yield environment of recent years, supported by its dividend, but investors need to understand what is likely to drive the stock in the future, as this dividend impact can be quickly overwhelmed. The same is relevant in the credit markets: buying a high yielding corporate bond may look attractive, but it is critical to understand the drivers of the credit exposure, as again a years’ yield can be very easily wiped out in times of volatility.
Central banks are likely to keep rates at very low levels for a number of years, well below those which existed pre-GFC. Australian Banks have significantly increased their capital bases following the regulatory push to increase capital and liquidity. The combined effect is that rates on term deposits are likely to remain at very low levels at least for the next couple of years.
Investors need to understand the risks they are taking in seeking to cope with this low yield environment, and to weigh up the need for income with the risk to capital from an increase in volatility.
Fitzpatricks Private Wealth Pty Ltd, ABN 33 093 667 595, holder of Australian Financial Services Licence 247429. The information in this publication is of a general nature only. All information has been prepared without taking into account your objectives, financial situation or needs. Because of this, we recommend you consider, with the assistance of a financial adviser, whether the information is appropriate for you. Please note past performance of an investment is not a reliable indicator of future performance.