Bonds are back. Many investors, perhaps rightly, shunned all but the highest-yielding areas of the asset class in the go-go years, preferring the much racier returns on offer from commodities, equities and property.
But investors are realising just how big a proportion of the returns they witnessed were simply the result of leverage. The entire global financial system was built on debt, which is being rapidly withdrawn.
Mass deleveraging has two profound effects on the global economy: slowing growth and plummeting inflation. The best thing investors can buy in such an environment is a good-quality asset that pays a decent, fixed level of interest. For this reason, there has never been a better time to invest in bonds.
Interest rates are being slashed around the world. As recently as August the key risk to western economies was identified as escalating inflation, but now the market is coming round to our long-held view that central banks will be grappling with deflation, not inflation, in a year’s time.
The oil price has collapsed by more than half since the record high it hit in the summer, while food prices are also starting to tumble. Inflation rates are starting to fall sharply, and all indicators point towards a real and sustained risk that Britain and America will go into deflation next year. The same is probably true of continental Europe.
We have been fighting the case for deflation for months based on what history has been telling us. Past credit crises have resulted in inflation falling, as the reduced availability of credit makes corporate and consumer borrowing more difficult. Inflation fell sharply in the aftermath of each of the last century’s banking crises, notable among which were the 1929 stockmarket crash, the Asian financial crisis and the Japanese boom and bust. There was never any reason why this one should be any different.
Government bonds have been just about the only asset class to do well over the past 18 months, but has the rally run its course? I do not think so. There is a real chance that we will witness Zirp – a zero interest rate policy – in many countries and the market is not pricing this in yet.
Interest rates will go lower than the market expects, and, most importantly, will stay lower for longer. In Britain, at the time of writing, the market expects interest rates to fall to 1.5% at the end of 2009 but then to rise to 2% in 2010 and higher thereafter. A brief “V-shaped” recession is priced in, but it is likely to last for longer than is expected.
If this forecast is correct, we could see a sustained bull rally in government bond markets across the globe. To get a glimpse of what happens to government bonds during a deflationary period, look at Japan. At the end of the 1980s, when the country’s property market bubble burst and its banks got into difficulty, interest rates were cut all the way down to zero as deflationary pressures began to take hold of the economy. A huge rally in government bonds ensued. Yields plummeted from 8% at the start of the 1990s to 0.5% in 1998, and investors received an annual return of about 9% for almost a decade.
What about corporate bonds? Investment grade corporate bonds were an unattractive asset class from about 2006 until recently.
The excess yield investors were paid for owning corporate bonds over gilts was tiny, and interest rates and inflation – both of which are unfavourable to corporate bonds – were rising. There has been a dramatic change – American BBB-rated bonds have gone from being the tightest in a decade to the widest since July 1932, as shown in the chart.
To say that investment grade bonds are unattractive, you have to argue that things are going to be worse than in the 1930s. The market has already priced in a re-run of 1931-32. But it is unlikely that we will see a repeat of the Great Depression because policymakers have learnt lessons from that period and the many recessions since.
Banks are being saved, fiscal stimulus is going to be undertaken and monetary policy is being rapidly eased. And even if we do end up in a worse situation than the 1930s, you could do far worse than hold investment grade corporate bonds.
High yield bonds are also looking good value for the first time in many years. The average high yield bond yields over 20%, but yields are high for a good reason – there are going to be many defaults. As in the investment grade arena, the high yield market is pricing in an unprecedented level of defaults.
However, the high yield market has not been “tested” by a recession on the scale of that which occurred from 1981 to 1982, or that of 1974 – not to mention a Great Depression, and that makes me slightly more cautious. The high yield market only really came into existence in the mid-1980s, so we lack the comfort blanket that history can provide.
That said, it is unlikely that most high yield bonds will default, so there is a lot of money to be made if you have a proven investment process and a strong credit research team that can help you avoid the losers. The easiest prediction to make is that good quality bonds will beat cash.
As Warren Buffett, a prominent American investment guru, said in October: “People who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value”.
His point on depreciation is not necessarily correct, because if we experience deflation, cash will not depreciate. But investors who buy bonds are locking into a high fixed rate of interest. That will be enormously attractive as interest rates head towards zero.