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Last month Mexico issued $1 billion of 100-year bonds, the biggest century deal ever and the first from a Latin American issuer. On average, on every day since, more than 100 Mexicans have been arrested and 30 killed in the long-running military campaign against drug cartels. The country’s late 19th-century, early 20th-century president, Porfirio Diaz, famously commented that “poor Mexico” was “so far from God and so close to the United States”. This was not previously thought to be a prophecy on bond yields, although the century bond trades at just a 235 basis point premium to 30-year US treasuries. Diaz defined Mexican politics for three decades. He was ousted in a revolution in 1911 and died in exile in Paris. Mexican bondholders over the past century have endured similarly mixed fortunes. The country defaulted in 1982 and needed a US-coordinated bailout in 1994. Mexico is far from being the only sovereign creditor whose bonds seem expensive. The 2030 issue from the Republic of Philippines, scene of two revolutions since 1985, yields a little over 5%. The 10-year government bonds of the UK and the US, two countries that are no strangers to bouts of inflation intermixed with currency devaluation, yield less than 3%.
Investors should be sounding the risk klaxon. They are not. Two factors are at work. First, defined benefit pension schemes around the world are increasingly concerned to match their assets and liabilities. In practical terms this means an asset allocation shift from stocks to bonds. The average UK pension fund has more than doubled its domestic fixed-income weighting since the early 1990s. The allocation to UK and overseas equities has commensurately fallen, from a high-water mark of 81% in 1993 to 54% in 2009.
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The strategic desire to de-risk pensions is sensible. Tactically, it smacks of investment illiteracy |
The second factor is equity revulsion among retail investors. Savers have given up on equities after two burst bubbles and negative real returns over the past decade. Even after the recent rally in equity markets it looks certain that bonds will once again outperform in 2010, which will only serve to reinforce this bias. The MSCI World Index is up around 4.8%, but the US 30-year treasury has a total return of close to 30%. The UK 10-year gilt has gained around 14% year-to-date. US bond funds attracted net inflows of $410 billion over the 12 months ending 30 April. The bid for bonds has never been so big. That’s good news for fiscally challenged governments. It remains to be seen if it will be equally positive for investors. Retail investors are often a contrarian indicator. Buying at the top seems imprinted on their DNA.
Big institutional investors, particularly defined benefit pension schemes, are being driven by two other forces: the agendas of their corporate sponsors and regulation. It is now a well-worn cliché to note that British Airways is a big pension fund with a small airline attached. But it betrays how critical the funding of defined benefit plans has become to their corporate sponsors. On the regulatory front, the pressure to meet solvency requirement is such that Philip Neyt, the president of the Belgian Association of Pension Institutions, has said that the repudiation of equities could stifle growth in Europe.
Regardless of any economic collateral damage, the investment case for bonds, whether nominal or inflation-linked, is increasingly difficult to make. To go back to brass tacks, nominal yields on government bonds should broadly reflect nominal growth (real growth plus inflation). Ten-year bond yields at less than 3% are priced for a Japanese-style lost decade of deflation. That is precisely what the Bank of England and Federal Reserve are determined to avoid. The printing presses are once more on standby.
Yields might continue to fall and short JGBs has been a trade that has ruined many investment careers. However, Japanese policymakers made a series of catastrophic errors before finally stumbling on the magic formula of zero interest rates, financial system repair and quantitative easing between 2000 and 2003. By then deflation was endemic. This is in complete contrast to the prompt, forthright and inventive policy prescriptions employed throughout the G7 over the past few years.
It is particularly intriguing that yields are falling to record lows for nominal bonds and breakeven rates are rising for inflation-linked bonds. Nominal bonds are pricing in deflation; inflation-linked bonds the opposite outcome. Markets could be schizophrenic. What is more likely is that this reflects pension fund demand: for interest rate hedging (buy nominal bonds) and for inflation hedging (buy linkers).
Asset liability matching is distorting markets. The strategic desire to de-risk pensions is sensible. Tactically, it smacks of investment illiteracy. The forward yield on the FTSE100 is about 3.8%. All long-run studies of investment returns stress the importance of dividends as a source of investment returns. In any outcome other than Japan in the 1990s, or the UK and US in the Long Depression of the 1870s, government bonds offer no value. De-risking looks like an increasingly risky business.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own
