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Bonds v equities: the view from four experts
by Dylan Lobo on Nov 21, 2012 at 14:02
With investors getting more comfortable with risk, we get an insight from four leading experts on whether equities or bonds are a better investment bet.
‘Although we think the yield on 10-year Treasuries will fall back soon from almost its highest level in five months, the medium-term prospects for bonds are far from rosy. Indeed, we think the average annual real return is likely to be negative over the next decade.
‘On average, the 10-year Treasury yield has not tended to rise in earnest until seven months or so before the Federal Reserve has begun to raise rates. The central bank suggests that “exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”, so bonds should remain supported by very accommodative monetary policy for the next couple of years at least. ‘We also expect the crisis in the eurozone to flare up again soon and the region to break apart eventually, triggering renewed demand for safe havens. As a result, we forecast that the 10-year Treasury yield will drop back to 1.5% from 1.8% and remain there or thereabouts through the end of 2014. But even in the unlikely event that the yield fell to 1.5% by the end of 2012 and remained there for much longer than the next couple of years – say, for a full decade – the average annual real return during this period would be negative unless the rate of inflation were less than about 1.9%.
‘A negative annual average real return on 10-year US Treasuries over the coming decade is not an attractive prospect, even in a new normal world.’
Much has been made of the fact that the outright yield on high-yield bonds has dropped below 7% (admittedly a rare event) and is approaching all-time low levels. In our view, the key here is the record low levels of government bonds. Credit bonds of all complexions price against the government bond curve.
We believe a more apt measure may be the spread over government bonds. Undoubtedly, spreads around the 650 basis point (bps) region for high-yield bonds look low. But in the past, the market has been below 300bps on two separate occasions, in 1997 and 2007.‘In hindsight, those turned out to be bubbles, in the sense that the low spread was followed thereafter by starkly negative performance by the asset class at the sub-index level.
‘A comparison of the ratio of credit yields to government bond yields reflects not only the fact that spreads are still some distance from their previous lows, it also shows that the ratio of credit yield to government yield has doubled from four reached in 2011.
‘That is to say, an index-level investment in high-yield bonds now yields an interest rate eight times as much as a government bond of the same maturity. The only other time this ratio was achieved was in the credit crisis. While there are some concerning signs in the credit markets generally, it is likely premature to refer to it as a bubble.
Peter Perkins, founding partner and global strategist, the Macro Research Board
‘The long-term outlook for government bonds is abysmal. Low current nominal yields translate into near-zero returns in real terms over the coming decade across most developed markets. Corporate bonds (including high yield) produce much better absolute and relative returns, although much lower than in the past decade. Emerging market sovereign debt strongly outperforms developed market government bonds.'
‘Higher starting yields imply better gains from reinvestment than government bonds will provide, especially as bond yields trend higher. ‘Real returns are highest for the US and euro area high yield debt, although downside risks and volatility will also be higher. Nonetheless, assuming historically normal net default rates and spreads over government bonds, they should significantly outperform government debt over the 10-year period.
‘A caveat is that returns are sensitive to the profile of the default cycle, early defaults reduce overall returns. Investment grade bonds produce modest positive real returns, albeit sufficient to outperform government bonds. Emerging market debt should also generate outperformance in light of higher current yields and negligible/limited default risk. Emerging market sovereign debt periodically faces elevated liquidity risk when global financial conditions tighten, but fundamental drivers are positive. In the long run, returns on emerging market local currency debt should also benefit from exchange rate appreciation versus the US dollar.’
While the gloomy macro news surrounding the US, eurozone and China continues to be dictating the market’s direction on a daily basis, some of the more recent fundamental news, such as unemployment figures and certain company corporate profits, seem to be rather better than some of the consensus numbers. This, in turn, might indicate that we are somewhere near the bottom of this current economic downturn. 'Indeed, over the next 12 months we might even experience a rise in global growth, even if rather tepid. Given that over the next 12 months, returns on core Western government bond markets and cash will give investors negative real rates of return, adjusted for inflation, it may now be necessary for them to consider investing in a growth and income strategy.
‘Indeed, investors will need to consider increasing their risk appetite by focusing on high yielding bonds and global equity income, given that interest rates will remain lower for longer, and that equities look better value than sovereign bonds. Therefore, it would seem rather logical for the longer-term investor to hold these asset classes pending any pick-up in the global economy. We believe global equities offer the most upside potential over the next 12 months, certainly with the possibility of further monetary stimulus. However, it might turn out to be a roller coaster ride for equity investors over that period.’