For decades, investors in European government bonds could sleep easily and at the same time enjoy annual returns of 7 per cent, but those days are over. In absolute terms, interest rate levels have fallen to new lows. Even a “friendly” environment with interest rates remaining at low levels, would allow only modest nominal returns, and even lead to negative returns in real terms if you take into account inflation.
Public and private debt has reached critical levels and while a reduction is inevitable, it is unclear how this is to be achieved as there are a wide range of options, most of them determined by politicians. The risk of losses is rising for all concerned – private individuals and the public sector, borrowers and savers, domestic and foreign investors alike. This is exacerbated by a decline in structural growth rates, not least due to demographics. Cycles are tending to become shorter, with more frequent recessionary phases. The market’s reaction to these imponderables is expressed in greater volatility and rising risk premiums.
Consequently, there is a clear and lasting decline in the risk/return profile of bonds. However this core asset class cannot be ignored, as long as investors adopt an active strategy.
The passive investment style has reached something akin to cult status, giving rise to an entire industry, but it does have its limitations in the current environment including;
• Disability to anticipate structural changes.
• Replicating the past Acting pro-cyclically, and thus accentuating every trend.
• Indifference towards valuations.
• Excessively high emphasis on the ratings of rating agencies.
Active management can avoid these pitfalls by reacting to the structural challenges. Investment opportunities can be found even in today’s demanding environment through careful analysis of fundamental data and valuations.
Government bonds of most industrialised nations are currently unattractive and although small capital gains are possible over the short term, the expected returns over the medium term are modest. However, given that persisting “financial repression” is on the cards for the long term, a sharp rise in interest rates remains unlikely – the steep yield curve will therefore continue to offer a certain amount of nominal returns. Inflation will remain low in most industrialised nations.
That said, due to the historically unprecedented monetary policy, the tail risks have risen significantly. In absolute terms, certain inflation-linked bonds may also be unattractive due to the extremely low real interest rates, but they do offer effective protection against an unexpected rise in inflation, and as such are a sensible complement to traditional bonds.
Within the eurozone, resolving the structural imbalances remains a demanding and protracted task, and one that is highly dependent on unpredictable political processes. Despite cheaper valuations, peripheral government bonds remain risky in fundamental terms.
By contrast, emerging market government bonds in hard currencies offer better borrower quality. Their high yields justify increasing allocation to emerging markets. Investment grade corporate bonds offer one of the best risk/return profiles, due to solid balance sheets and high free cash flows. This asset class does not depend on strong economic growth to deliver good results and thanks to their cheap valuations corporate bonds are the preferred alternative to sovereign debt.
Bernhard Urech is head of fixed income interest rates at Swiss & Global Asset Management. The views expressed here are his own.