Bonds: little compensation for corporate risk
Source: Refinitiv, 31.3.21
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.
Bonds are supposed to be boring. Today they are not. Most investors tend to focus their attention on stock markets, but the headlines are currently all about bond yields. The echoes of the 2013 Taper Tantrum (and earlier disorderly periods in the markets such as in 1994) are loud and clear.
What everyone is focused on is the rise in government bond yields shown clearly in the chart in the Shares section above. The rise in yields is the consequence of a fall in bond prices (they move in opposite directions) and bonds have experienced one of their worst quarters in decades.
Bond investors are worried about inflation. They rightly see it as the enemy of fixed income returns. Anyone familiar with the long-term performance of bonds will know that inflation is a killer. And the reason they are worried about inflation? Well you don’t have to look further than the US government. Spending $8.5trn on defeating the coronavirus may be the right thing to do but it comes with significant risks.
The past 40 years or so have lulled bond investors into a false sense of security. A generation and more of falling interest rates has provided a tailwind for bonds. With yields close to zero, that bull market has nowhere to go. The only question is whether interest rates and bond yields are anchored at today’s low levels or start to rise significantly from here.
So, the risk of holding government bonds is higher than we have believed in recent decades. And the return for taking it is paltry. The good news is that after the recent rise, a bond yield can once again fall back to zero, providing a capital gain. In a low interest rate world that might provide some support.
When it comes to corporate bonds, the outlook is not much brighter. As the chart opposite shows, the expectation of an economic bounce back from the pandemic has reduced to historically low levels the gap between safe government bond yields and those on less safe corporate bonds. Investors are now accepting almost no compensation for the greater risks they are taking by lending to companies rather than governments.
It is true that less secure companies (the issuers of so-called high yield bonds) do offer something of a premium. But even here, as the red line on the chart shows, the income is not that much higher when you factor in the greater chance that a company will default.
The area of the bond market that looks most interesting is in emerging markets where both government bonds and corporates offer more yield than in the developed world and arguably not that much greater risk. It’s thin pickings though. Bonds offer investors a degree of diversification, but you are paying a high price and taking a big risk for a small benefit.
Important information: There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall.
Unlike shares, commodities really do reflect what is going on in the world as we speak. Shares look to the future, but commodities are real assets and their price reflects demand in the here and now. This partly explains why metals and oil have slightly run out of steam in the past quarter. China looks less interested in stimulus than the West and fears of new infection waves have temporarily put the brakes on re-opening in some places.
But the case for a new structural bull market in commodities remains strong once we get over this short-term hump. There are three main drivers. The first is vaccines which will provide a major boost to demand for commodities as people start to travel and consume again.
The second driver is also about demand but this time a more permanent shift. It’s to do first with governments’ approach to the Covid shock, a new focus on income redistribution towards lower income groups who are more likely to consume than save. It’s also about solving the climate crisis. Ultimately this will demand huge spending on commodity-intensive infrastructure. Goldman Sachs analysts think that might add up to $16trn over a decade.
The third driver is supply. After years of excess investment and oversupply, the problem now is a lack of spending thanks both to Covid disruption and a desire to invest less and return cash to shareholders. Shortages are already showing up.
Commodities are a great diversifier in a portfolio. During the dot.com crash in 2000, commodity markets rallied strongly even as shares lost half their value. They also perform well in an inflationary environment.
The real estate market continues to be driven by the ‘gravity of yield’. With an acceptable income hard to find in the bond market, the return on prime property assets of 3-4%, often with long, secure income streams, continues to be compelling. Obviously, property yields need to be higher to reflect illiquidity and depreciation but, even so, the sector is still relatively attractive to income seekers.
The UK is likely to be a beneficiary of this wall of money thanks to the higher yields available here, even after Brexit. The completion of a free trade deal with the EU, albeit with some teething problems, has taken away some of the perceived risks of investing in the UK and an extra 1% of income will at the margin tempt back some capital from the more in-favour European markets.
There are risks in the sector. First and foremost, the changing nature of the post-Covid economy means money is pouring into hot areas like online logistics. Expectations of rental growth may be disappointed, and price rises in the sector have been rapid. Another risk is that investors compromise on quality as they chase yield. In a new working world in which offices are competing with desks at home, only the best environments will attract tenants. A third risk is the danger of extrapolating from the experience of the past year into the future. Some things have changed for good; in other ways the new world may look surprisingly like the old one.
Important information: Funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to sell/cash in this investment when you want to. There may be a delay in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact.