The recent rise in bond yields is the beginning of a worrying longer term trend, according to leading investment experts, with a number of them warning that the bubble in fixed income is finally bursting. 
Following a phenomenal period last year thanks to falling inflation expectations, weaker than expected economic growth and geo-political risks, the prices of UK, US, German and Japanese government bonds have all started to fall over recent months despite the fact that headline inflation remains low and the likes of the ECB and Bank of Japan have ramped up their quantitative easing (QE) programmes.
European bonds have been the worst hit due to improving economic data, as yields on 10-year German bunds have risen from lows of 0.05 per cent earlier this year to their current level of 0.67 per cent.
Ten-gilts have sold off considerably as well, as yields have risen by more than 40 basis points over the past month leaving them at their current level of 2 per cent. As a result, FE data shows the Barclays Sterling Gilts index is down more than 5 per cent since the end of February.
Performance of index since Jan 2015
Source: FE Analytics
Bill Eigen, manager of the JPM Income Opportunity fund, has long held the view that the current fixed income market is dangerous as sovereign debt is simply not priced correctly due to years of unprecedented central bank intervention.
He says the extreme moves in bund yields is warning sign that the bond market had reached bubble territory – given the negative yields that were on offer earlier in the year. He expects this trend to continue as economic data is now improving.
“As recent European inflation data shows firming prices, volatility has followed across the European rates market,” Eigen (pictured) said.
“The spike in 10-year German bund yields from 18 basis points to over 50 basis points in a short period – during which investors would have lost more than 10 per cent in total return terms – is an illustration of the bond market’s extreme susceptibility to slight interest rate movements.”
“In today’s market, traditional fixed income approaches may be significantly challenged if deployed on their own, without diversification.”
He added: “Investors would be wise to focus on stability, reducing the likelihood of capital losses and preserving capital. We stand ready to capitalise on further volatility, which we would expect to continue.”
Fixed income has been one of the best asset classes for investors over the very long term.
Our data on the IA UK Gilts sector spans back to December 1989, over which time the average fund has returned 320.5 per cent. While those gains are considerably lower than equities over that time, the low volatile nature of bond returns over recent decades is all too clear to see in the graph below.
Performance of sector versus index since Dec 1989
Source: FE Analytics
In fact, the average fund in IA UK Gilts sector has had a maximum drawdown – which measures the most an investor could have lost if they bought and sold at the worst possible times – of just 13 per cent, which is close to four times lower than that of the FTSE All Share.
However Chris Iggo, chief investment officer of fixed income at AXA Investment Managers, warns that the recent falls in the bond market could be the start of a prolonged downturn in the asset class.
“Is it the end of the bull market? Is it the start of the bear market? Market behaviour is not conclusive either way, largely because the fear of illiquidity is preventing most participants from committing much risk capital to a strong active view,” Iggo said.
“What I take from the recent price action is that more and more investors are avoiding negative or very low yielding bonds and more and more think that reflation is actually taking place. Bank lending in Europe is starting to increase, oil prices have stabilised and US wages are picking up.”
“Inflation markets have responded to that and should continue to do so. Everyone has thought bond yields would rise at some point. Reality check – it might be now.”
There are experts who disagree with that view, however.
The commonly used argument within the bond bull community is that yields are unlikely to spike too much given that economic growth is set to remain relatively weak and inflation will stay low as there is still too much debt in the system and overcapacity in the global economy.
Others point out that while interest rates are expected to rise at some stage in the not-too-distant future, central banks will be keen keep monetary policy supportive so they don’t choke off their country’s economic recovery.
On top of that, following years of ultra-low interest rates, some expect institutional investors and pension funds – who are crying out for higher levels of income – to provide a natural ceiling for bond yields.
It is also true that warnings of a bond market collapse have been widespread over recent years.
Following the market sell-off in May/June 2013 – when the US Federal Reserve warned it would start to “taper” its QE programme – the consensual view was that 2014 would be a disastrous year for bondholders as the economic picture improved and the added liquidity which had propped up the asset class started to disappear.
However, as the graph below shows, almost the complete opposite happened meaning that most investors who decided to go overweight equities instead were hit hard.
Performance of sectors versus index in 2014
Source: FE Analytics
Nigel Cuming, chief investment officer at Canaccord Genuity Wealth Management, says there are certainly factors at work which could force yields back down again. However, he says this will only create an even more inflated bubble to burst later down the line.
“Given that the European Central Bank has only recently started its QE programme there is a possibility that despite being an asset class bubble that is waiting to burst, yields on bonds could venture further into negative territory in the short term,” Cuming
“Given the impending rate rise professional investors are increasingly concerned with duration risk and have begun to favour strategic bond funds which manage duration on an active basis and are defensively positioned. “
“This is particularly important because there is such limited liquidity in bond markets at present, there is a very real danger that if there is a market shock which prompts panic, it will be very difficult to sell positions, especially those with longer maturities.”
