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Are Government Bonds in Developed Markets Overvalued ?

Every asset class has to continuously prove that it offers value. And government bonds are no different. After a 27-year bull run, where the prices of government bonds in the developed world rose fairly consistently from a low in 1982 to a peak in 2008, it is now arguable whether government bonds in the developed world compensate for the two principle risks of inflation and default. 

US 10-Year Bond Yields - Feb 2011

Rising government bond prices equal declining bond yields and, as the accompanying Chart A highlights, yields on the key US 10-year government bond declined from over 14% in 1982 to near 2% in late 2008. By way of an example, let us assume that the yield on a 10-year government bond rises to 6% from 5%. Under this scenario, the price of the 10-year government bond will decline to offer the new investor the equivalent of a 6% per annum return over the remaining life of the bond. In practice, then, rising bond yields reflect falling bond prices and declining bond yields, as has been the case in the developed world since the early 1980s, reflect rising bond prices.

Is the increase in bond yields since last summer the turn in what has been one of the most lucrative runs in bonds markets seen in the last century? Or put another way - do current US bond yields of 3.43% (28th Feb) compensate investors for default and/or inflationary risks? The importance of the argument can't be understated. Most, if not all, pension funds have significant exposure to bonds on the basis that it is a non-risk asset.

I find it useful to look at the performance of government bonds over a longer term perspective to see where we are in the cycle. Inflation was gradually subdued in the early 1980s allowing both short term interest rates and long term interest rates (bond yields) to decline, and they declined for a period of twenty seven years despite frequent counter-trend rallies. The decline in bond yields since the early 1980s has been a true long term bull market.

US & UK Real Bond Yields - 1950-2010

Chart B summarises the real returns (i.e. after inflation) that investors in longer dated US and UK government bonds have obtained every decade since 1950 and, in aggregate, over this sixty-year period. Government bonds are supposed to offer a guarantee of capital. As a consequence, and like cash deposits, they only have to provide investors with a modest return over and above inflation. The US 20-Year government bond provided a 2.1% compound per annum return over inflation over this sixty-year period. In the UK, the long term real return from bonds over the same timeline was somewhat lower at 1.3% per annum.

In both economies, negative real returns in the 1950s, 1960s and 1970s gave way to the super-sized positive returns in the 1980s, 1990s and 2000s. In fact, over the past 30 years, real bond returns after inflation in both the US and UK have been on average 5.9% compound per annum - some three to four times the long term average respectively.

The US 10-year bond currently yields 3,43%. Based on the long term real return of 2.1%, then investors must be expecting US annual inflation to average only 1.4% over the long term from here. That hardly constitutes a margin of safety. Indeed, it does not factor in any risk of default. Obviously, it would be unthinkable for the US to default but then how does one distinguish between using money printing to inflate debt away and actual default? When push comes to shove there is probably not too much of a difference!

In that context it is fair to ask - is there a bubble in bond valuations? On the NO side there are some persuasive arguments led by economists such as Paul Krugman, economic Nobel prise winner. The emergence of Asia with cheaper goods and lower labour costs has been highly deflationary for the developed world. It addition, the weak banking system and high levels of consumer debt which, following the global banking crisis, has driven up private savings, will likely act as a drag on growth for years to come. Against that backdrop, inflation is likely to remain muted even if fiscal spending stays high.

On the YES side are the arguments that demand for bonds has been inflated by both the quantitative easing programmes of the central banks themselves and the near zero cost of short term money.

My own view is that the mentality of the US and UK governments has always favoured growth and jobs over inflation and if we do not see a pick up in employment levels authorities in these two countries are unlikely to hesitate to print money to escape the debt trap. With visible cracks in the Euro-zone, Germany's resolve to such inflationary tactics could easily weaken. Also, commodity price inflation is a fact of life. For these reasons, I believe bond yields at these levels hold no attractions. Of course, buying overvalued bonds is not are as dangerous as buying overvalued equities, property or other asset classes. As long as they hold the bond(s) to maturity, investors at least get their capital back even if they have lost some purchasing power.

But every asset class even if overvalued in aggregate can offer value in certain areas. Equity markets were grossly overvalued in 1999 because technology stocks were so hyped. But traditional stocks had been left on cheap ratings and delivered good returns since.

Do Irish Government Bonds Offer Value ?
Irish government bonds crashed in the last quarter of 2010, as investors threw in the towel on Ireland's banking and fiscal mess. Between the government's fiscal crisis and the banking recapitalisations, Irish sovereign debt is estimated to increase by €100-110 billion over the €25-30 billion of government debt that was already in place pre the crisis. Overseas investors understandably had had enough and feel the only answer is for Ireland to restructure its debt.

But a crash in any asset class holds the seeds of opportunity. In times of great uncertainty, as Ireland is in now, investors are capable of over reacting. When the equity bear markets of 2007-09 ended in early March 2009, the familiar sign of market capitulation was evident - that event where investors throw in the towel and sell irrespective of value for fear that markets might keep falling. No one rings a bell at the bottom of bear markets but the fact is that equity markets have been recovering ever since and capitulation by investors from October 2008 to March 2009 indeed marked the bottom.

In August 2010, the yield on Irish 10-year government bonds was under 6% but by mid November it had ratcheted up to over 9% where it remains today having been range bound between 8.3-9.5% since. Such sharp price falls in October through November (rising bond yields) in such a short space of time may well have signalled capitulation - an acceleration in the trend as investors in Irish bonds threw in the towel and, in so doing, priced in all the bad news and more.

In assessing the value or risk, investors need to look at some figures and stay away from the headlines. A benchmark Irish Government 10-year bond was issued in January 2010 at €100 with an interest coupon of 5%. It was trading at €73 on Friday last. At that price, the annual yield is 6.8%. And if the government repays the €100 at maturity in 2020, a capital gain of circa €27 is also on offer, providing a combined yield to redemption of close to 9.4% (annual coupon plus capital gain).

By pricing the bond at €73 when there is a government guarantee that it will be repaid at €100 in 2020, investors, in aggregate, are saying that any restructuring of Irish government debt could shave 27% off the amount owed at the 10-year end. Is this realistic? I think it's fair to say that none of us know for sure.

But a 9.4% yield to redemption is an equity-like return and it appears to me that investors are now being adequately compensated for the risk of default. After all, if only €73 is repaid in 2020, today's investor still gets the annual income of 6.8% which on its own is still well ahead of current bank deposit rates.

In the current very uncertain environment, I class Irish government bonds as a risk asset and if you are prepared to take some risk then I believe you have been presented with the buying opportunity. Reading today's media headlines tells you what is going on but it does not tell you what is priced in. While no one rings the bell at the bottom, I believe that Irish bonds may well have bottomed in mid November last - but only time will tell whether this is indeed so!

Rory Gillen
1st April 2011