The long-term history of bond markets suggests that investors should brace themselves for debt defaults in the coming years and ask questions about when the fixed income bull run will come to an end, according to Bank of America Merrill Lynch (BofA ML).
BofA ML’s annual ‘The Longest Pictures’ report analyses financial markets over a multi-decade or even multi-century viewpoints to show how various assets have performed over the truly long term. As American investment consultant Charles Ellis said: “The average long-term experience in investing is never surprising, but the short-term experience is always surprising.”
With the UK seeing its credit rating cut after the Brexit vote and investors flocking to fixed income in search of safe havens, bonds are very much in mind at the moment. We’ve scoured the report to find charts that could offer some insight for bond investors.
The history of sovereign debt defaults
Source: BofA Merrill Lynch Global Investment Strategy, www.carmenreinhart.com
The above chart shows how many external sovereign debt defaults and reschedulings that took place between 1800 and 2010. BofA ML says it should serve as a caution that more will be seen in the near future.
The bank argues that minimal deleveraging has taken place since the global financial crisis, despite much attention on austerity. As a result, excess sovereign debt remains a global phenomenon and default risks remain high.
“During 2015, sovereign default risks rose significantly in a number of countries, e.g. Greece, Ukraine, Venezuela, Nigeria, Brazil,” the bank added. “The history of the past 200 years clearly shows that investors should not be at all surprised by further defaults and debt rescheduling in coming years.”
The Twilight Zone… no “great rotation”
Source: BofA Merrill Lynch Global Investment Strategy, Ibbotson, Bloomberg
At the peak of the bull market, there was much talk about when the ‘great rotation’ away from bonds – which investors had piled into thanks to quantitative easing and ultra-low interest rates – and back into equities would occur.
“And yet the bull market has waned in the past 18 months, there has been no ‘normalisation’ of growth, rates and asset allocation, no ‘great rotation’, and bonds and stocks have been trapped in a Twilight Zone of volatile trading ranges,” BofA ML said.
This ‘Twilight Zone’ has been driven by policy, or concerns over Federal Reserve rate hikes as well as ‘quantitative failure’ in Europe and Japan; a ‘recession’ in profits, driven by slowing growth in China and the weak oil price; and valuations, as excess returns are more difficult to come by in an era of maximum liquidity.
UK base rate since 1705
Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg
In its 300-year history, the Bank of England has never taken interest rates below 0.5 per cent – where it stands today, having last been moved on 5 March 2009.
Over more recent years, talk had turned to when the Bank would follow the Fed and start to move the base rate back towards historical norms (over the 10 years before it was taken to 0.5 per cent, the average base rate was close to 4.75 per cent). It was even suggested at points that the Bank of England could move before the Fed.
Following the UK’s decision last week to leave the European Union, however, many have suggested that the base rate could be cut again – possibly as soon as July.
Record corporate bond prices
Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg
While the headlines tend to focus on the movements in stock markets, the fact that corporate bond prices have reached record highs is well known.
BofA ML points out that a “cocktail” of quantitative easing, zero interest-rate policy and negative interest-rate policy has been a “potent one” for assets over the eight years since the global financial crisis. These conditions have been “especially intoxicating” for those assets that offer a combination of yield, quality and growth – which are deemed to be scarce in the current low growth, low interest rate world.
But the corporate bond rally started long before the financial crisis. The Dow Jones Corporate Bond index is currently 27 times higher than it was in 1980m representing the greatest bond bull market of all time.
US 10-year treasury yields since 1790
Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg
The yield on US 10-year treasuries fell to 1.45 per cent in July 2012 – the lowest they had been in 220 years and a level that has yet to be breached. Today, yields stand a 1.46 per cent.
BofA ML notes that there have been a number of distinct secular bull and bear markets in US bonds:
1790 to 1902: Erratic yield fluctuations, followed by a sustained decile to below 3 per cent
1902 to 1920: The first bond bear market, when yields rose from 3 per cent to 5-6 per cent
1920 to 1946: The first great bull bond market, as yields fell from 5-6 per cent to below 2 per cent
1946 to 1981: The second bond bear market, which saw yields climb from 2 per cent to more than 15 per cent in 1981
1981 to 2016: The ‘greatest’ bull bond market. Yields plummet from 15 per cent to the current lows of around 1.4 per cent