Investors awaiting higher yields on government bonds have systematically been missing out for four decades. While market rates are rising, bondholders remain on the edge of their seat. With central banks set to tighten monetary policy, the question is: who is going to buy government bonds?
American and European government bonds, both short-term and long-term, have been yielding less and less for decades. The real return under current market conditions is in many cases even negative. Many prominent billionaire investors, including CEO Ray Dalio of hedge fund manager Bridgewater, even call buying government bonds ‘a stupid move’.
Treasury yield above 2%
The yield on US 10-year government bonds, which has been falling systematically, climbed above 2 percent last week for the first time since August 2019 as investors dumped their bonds after the US Bureau of Labour Statistics (BLS) published its latest, alarming, inflation figures. The US consumer price index rose 7.5 per cent year-on-year in January - the highest annual pace since 1982, BLS said.
While the yield on the US 10-year bond, the benchmark for financial assets around the world, rose by about 50 basis points so far this year, the question remains whether rising yields on government bonds will continue, and who, should yields not rise significantly, will ultimately want to invest in this asset class.
Central banks ending asset purchases
Persistent and rising inflation is a thorn in the eye of central banks worldwide, and so monetary tightening is set to take place this year. Buying up of government bonds will thus be phased out.
The Bank of England has already stopped, the Federal Reserve will stop in March, and the ECB will probably stop its monetary easing in the third quarter. In the case of the ECB, redeemed bonds will still be reinvested, but the ECB will eventually start reducing its balance sheet.
Banks seen cushioning the exit
Hendrik Tuch, head of fixed income at Aegon Asset Management, says banks and institutional players like pension funds and insurers will be the ones to cushion central bank exit.
Banks can invest in government bonds if the curve is steep enough. Banks can still make returns of more than one percent when interest rates rise slightly, because the money can be obtained from savers at a rate of 0 percent.
Funding levels among US institutional investors are such that they will slowly but surely make the turn from equities to bonds, according to Tuch. In the United States, where the ageing population is growing rapidly, the population will eventually allocate more savings to bonds, he said.
In Europe, too, banks are a potential source of those purchases, the bond strategist says. He anticipates that large pools of money from China and the Middle East will then also be allocated to European and US government bonds.
“As soon as interest rates in the 5- to 7-year segment have risen sufficiently, government bonds will become interesting investments again,” he said.
Government budgets watched
Typically, the appeal of sovereign debt is linked to a country’s savings, such as pensions. Therefore, according to Erik Schmahl, senior investment strategist at Rabobank, most developed countries will be able to continue financing themselves, even in the current interest rate environment.
So the problem is not that no one wants to lend money to Western governments, Schmahl said. Governments only have a problem financing their public debt when they heavily depend on foreign states or when their own population no longer wants to finance them. Stopping central banks from buying up a large proportion of sovereign debt will, he said, cause encourage investors to demand higher interest rates.
Are governments making the right investments?
Low interest rates give European governments the opportunity to make substantial investments that, if used properly, will quickly be recouped. “If that opportunity is not used properly and governments fail to strengthen growth, then investors will start to doubt the effectiveness of government policy. But a rich country that can raise taxes can always gets its national debt financed.” Schmahl said.
For bond investors, it is a matter of muddling through until interest rates appear on the horizon again. Until then, he said, there is more potential in other assets, such as equities.
No talk about ECB TLTRO’s
Tuch however is not convinced there is more potential in equities. Monetary tightening is not a good time for the market, so Aegon AM is neutral on equities.
“I would have preferred an underweight. Not all the monetary pain is yet priced in - either in equities or bonds,” Tuch said. ”The market is very focused on rate hikes, he said, while nobody is talking about TLTROs.”
So-called TLTROs, or targeted longer-term refinancing operations, are arrangements whereby banks can borrow from the ECB at -1 percent.
Overweight in inflation-linked bonds
“They expire this year and involve a trillion euros, which will reduce the ECB’s balance sheet. As far as we are concerned, there is still too little talk about this and it has therefore not yet been factored into prices. We are therefore underweight in duration.”
“We want to keep the duration of the portfolio as short as possible. As far as I am concerned, we can be patient with being overweight for a while yet,” he said, adding that Aegon is overweight in inflation-linked bonds, but strangely enough there is not much demand for that product”, says Tuch.
This article originally appeared in Dutch on Fondsnieuws.nl and InvestmentOfficer.be: