Fixed income investors have been awaiting ‘normalisation’ for some time now, with many frustrated with the lack of progress in this adjustment process. Economic theory would suggest that the ‘normal’ level for a long-term risk-free rate of return from a Government bond would be equal to the rate of growth in the economy plus the rate of inflation. Typically, with annual economic growth rates and inflation rates in the region of 2% to 3%, bond yields in the region of 5% to 6% would be expected.
Those of us who are not millennials fondly recall the 1980’s and 90’s, when high single digit and even double-digit income returns were not uncommon seems almost unfathomable these days. Even if normalisation occurs gradually over time, bond yields are unlikely to ever return to those levels and even a move to where economic theory suggests should be the equilibrium level, is unlikely, particularly with distortions from an ageing population, pension scheme deficits and central bank policy.
How is this interpreted in TEAM portfolios?
TEAM has held the view for some time now that ‘normalisation’ is a theoretical debating point for those who choose to ignore the pragmatic realities of the world in which we live in today. Despite a temporary blip in 2013, when worries about an imminent withdrawal of Government liquidity pushed yields higher, resulting in a ‘taper-tantrum’, bond yields have edged progressively lower. This is unlikely to change any time soon and any temporary period of market weakness, as in the past, will be viewed as a buying opportunity.
Ultimately, we feel that bond yields will stay lower for longer and might even follow the path of Japan and Europe and move negative! This presents an obvious problem for lower risk investors seeking an annual income return in the region of 4%, since gilts and other higher-grade sovereign and corporate issuers will sadly fail to meet such aspirations.
An investor can choose to invest in UK gilts, in the hope that yields will eventually rise, but will incur potentially meaningful capital losses in the process, or can choose a blend of corporate bonds, such as Scottish Widows (BBB+ rated), Aviva (BBB) and Anglian Water (BB+), which combined produces a composite yield to maturity in the region of 4.50%.
Written by Tony Wood – May 2019