How low can it go?

“How low can it go?” – Whilst this phrase was once synonymous with the ever plummeting waistband of Britney Spears’ jeans, and the depths to which Kerry Katona’s drug-fuelled life could sink, it is a phrase now more commonly heard in the challenging world of bond investing.

As a seasoned bond holder, you will know that returns from bonds come from two sources - the income paid out in the form of coupons and capital gains made from price appreciation of the bonds. This price appreciation is made as yields fall. Currently the game looks potentially treacherous for bond investors. For one, yields on Treasuries and Gilts are ultra low already; between 1-2% for shorter-term bonds and 3-4% for medium term bonds. The prospect of any further price appreciation at times like this feels like pie in the sky. For another, interest rates having been cut to record lows to stave off recession have nowhere to go from here but upwards.

These are very real concerns and account for some of the reasons why this asset class remains about as popular as Tony Hayward at a 4th of July barbeque in Louisiana. Your inner investment voice of reason is no doubt pestering you to think about hunkering down in cash, after all you won’t be facing the principal losses that might confront you in bonds.

The Barclays Capital US Aggregate bond index, a broad index tracking US bonds, yielded 15% in 1981and began each of the following decades with yields less than the last. This period has generally been marked by declining interest rates. The yield of the aforementioned index now sits at a paltry 3.2%. If interest rates and yields pick up from here, bonds will have to contend with capital losses instead of capital gains.

While it is undoubtedly hard to get excited about an asset class that has a dark cloud of likely loss looming over it, it may be worth considering that although investors expect interest rates to rise, the central banks may not hike interest rates very quickly in a straight line, if at all.

As we move through into the second half of the year, a clearer picture of global economic health is starting to emerge. The recovery in the US, which was running in fits and starts, now appears to be faltering. In the UK, deficit cutting is likely to mean lots of job losses in the public sector. Consumer confidence is crashing and house prices are falling again too. In its quarterly Inflation Report, the Bank of England (BoE) revised down the growth forecast and reported inflation will likely stay above target well into the next year.

The BoE and the Federal Reserve in the US have consented to keep interest rates low to protect growth and the prospect of an eventual hike is getting pushed further and further into the future. And so bonds appear to be dodging that particular interest rate risk bullet for now.

There is something else that can drive bond yields lower. Scary as ‘Quantitative Easing – Round II’ sounds, it is not outside the realms of possibility. The Monetary Policy Committee (MPC) may have no choice but to step in and support a weaker than expected recovery with an additional round of QE. If you remember, this was primarily done through the purchasing of Gilts and any further buying may work to support prices and deliver that much desired capital appreciation. The MPC’s
equivalent in the US has announced just this week that it would be considering “reinvesting the proceeds of maturing mortgage backed securities in Treasury securities”. Isn’t this just quantitative easing by another name?

Scarier still is the prospect of deflation. Yes, that’s hard to believe when BoE has missed its inflation target for 42 out of the past 51 months. The Central Bank is in dire need of overhauling its forecasting models and is quite rightly taking much derision from market spectators. But there are many who point to spare capacity in the system and believe that inflation will fall to subdued levels as temporary effects such as VAT hikes and oil prices disappear.

The threat of deflation now poses a more serious immediate threat to the US economy than inflation. This dreaded D-word is akin to the He-who-must-not-be-named villain of the Harry Potter books. Under this scenario, prices of goods are expected to fall in the future and consumers, investors, and businesses postpone their spending which is lethal to economic growth. One need only look over to Japan and its ‘lost decade’ to see what happens when deflation becomes
embedded in the economy.

Whilst the Gods of monetary policy, AKA Ben Bernanke and his fellow Federal Reserve governors work to put in place stimulus packages to prevent a Japanese-style outcome, the mere possibility of deflation should have bond investors rubbing their hands with glee. If inflation is kryptonite for bonds, then deflation is whatever the opposite of kryptonite is. Bonds become attractive because they offer guaranteed coupons and a predictable selling price while equities and real estate will suffer from falling prices and returns.

Of course, under any deflationary scenario, the phrase ‘cash is king’ becomes the mantra. Holding cash will allow you to have options in an environment where asset prices are dropping and a bargain or two may be had.

So back to the question of ‘How low can it go?’ – well, the answer to that depends on the outcome of another question; ‘Will we get deflation?’. Should it materialise and hang around like a bad smell, there is nothing to stop yields tumbling lower and lower.

***

And finally... Numerous inexplicable things have happened in the City over the last few years and many of us would rather pretend that a lot of them were the stuff of science fiction rather than fact.

However, all the strange but earthly machinations of dealers, traders, financiers, brokers, underwriters, managers, advisers and bankers were put firmly into perspective this week with the news that the remains of a UFO had been discovered resting on the bed of the Thames just east of London Bridge. Quite apart from the question as to how anyone knows that the object, although undoubtedly unidentified, ever actually flew there are one or two more plausible explanations as to what it might be. Some theorists have suggested that it could be a wooden buttress from the old London Bridge, or that it might be the remains of a Second World War rocket. We think that our version is much more likely – it is the last resting place of a lorry load of collateralised debt obligations that their creator would rather stayed undisturbed for several generations.

The truth is out there!

Aparna Ram
Investment Research Analyst

Towergate Financial is not responsible for the content of this article. The opinions expressed therein are those of the author.