Dehn says quantitative easing and fears about the global economy have pushed investors into bonds and driven yields low, but these policies cannot continue forever and when they are reversed investors will take losses. He believes that once people look to sell out of US, UK and other safe-haven bonds they will find it almost impossible to find a buyer, as so many have invested in them in recent years.
"The greatest risk facing fixed income investors today may not be the European periphery, but how to manage the coming rise in US Treasury yields," Dehn said.
"We estimate that anyone holding a 10-year Treasury bond when yields return to their historical average stands to lose more than 30 per cent of their money."
"It may be too late to get out of Treasuries once it starts," he added.
FE Trustnet reported recently that investors are missing out on good companies due to excessive caution driven by macro events.
Dehn’s comments suggest the flight to safety – which he dubs the flight to liabilities – could have even worse consequences once policy reverses.
"There is no precedent for reversing QE of the magnitude currently in place. At best, when the time comes for reversing the current set of policies, the market will price in a material risk of policy mistakes."
"Not only may yields rise, they will also become more volatile. Rate volatility in turn will end the phoney war in currencies; FX markets will become extremely unstable too. FX weakness and higher rates will both work against holders of highly indebted country (HIDC) bonds," he said.
Returns on UK Gilt funds have spiked in recent years, but Dehn suggests this run is likely to come to an end.
Performance of index over 20-yrs
Source: FE Analytics
US Treasuries bear a particularly high risk, with data showing European holdings of the bonds grew by 67 per cent in the last year.
According to Dehn’s figures the average yield in the last 50 years for a 10-year US Treasury has been six per cent, jumping to 7 per cent when the spike between 1980 and 1985 is included.
If yields jump to 6.5 per cent from the current low, bond holders will lose 34 per cent of their capital.
"This risk is potentially many times costlier than a Greek default. It is a risk which investors should not ignore," Dehn continued.
He recommends emerging market debt to hedge against the risk, saying that because it is largely held by domestic investors such as pension funds, it is less exposed to yield rises in other government bonds.
"By contrast, all HIDC bonds are largely held by the same investors. A rise in yields in one HIDC market will therefore likely induce profit-taking in other markets, thus spreading the rise in yields with great speed," he explained.
However, he also thinks there is a danger to the world economy through the exposure of emerging market countries to the bonds of HIDC countries.
"Ironically, some of the most virulently anti-emerging market sentiment is found within emerging markets, particularly among central bankers."
"Emerging market central banks still allocate the bulk of foreign exchange reserves to HIDC bonds on the argument that these are more liquid."
"But what happens to liquidity when everyone sells at the same time? What happens when the great flight from liabilities gets underway?"
"Ultimately, the coming rise in US Treasury yields is a problem for all fixed income investors, emerging market central banks included," he finished.