A Perspective on Developed Market Bond Yields

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Bonds are generally included in an investment portfolio to provide diversification and return. Bonds in developed markets currently offer much lower yields than their emerging market counterparts, but are nonetheless perceived to be less risky and are therefore more popular. But is the safe option the best?

At Orbis, our investment principles are to limit the assumptions we make about the future and ignore the short term. This is unusual in fixed income securities, where many investors rely on macroeconomic forecasts over the coming months. Our investment philosophy, in all asset classes, including bonds, is the opposite of this thinking.

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Chart 1 is a remarkable reminder of the importance of getting it right. It shows the yield of the 10-year US government bond since 1970. Bond prices move in the opposite direction of bond yields, therefore consistently lower yields have resulted in consistently higher prices. An American bond investor in the 1980s needed one thing that was right, that inflation and therefore yields would go down, and would hold on to that belief for the next 40 years.

This downward trend in yields was not limited to US government bonds; government bond yields in most developed markets fell to zero, and negative for safe-haven securities like Germany and Switzerland. Even Greece, which seemed likely to default on its bonds following the global financial crisis, is now paying less than 1% of its public debt.

Corporate bonds have experienced similar yield compression, often regardless of underlying fundamentals. The Bank of America US High Yield Index tracks the debt of US companies rated below the investment grade, more commonly known as junk bonds. Junk bonds offered a yield of around 10% for much of the 1990s and 2000s. Investors were rewarded for taking the risk of “junk” credit. Today, in many ways a more difficult time than the 2000s, these bonds offer a historically low nominal yield of 4% and a negative real yield.

Low returns mean fewer opportunities

Low indiscriminate yields are a problem for long-term bond investors like us. More importantly, unlike opportunities in Africa, low returns mean there are fewer opportunities with an attractive likely return. They also negate two of the reasons we hold bonds in a balanced portfolio, namely to gain carry (“carry” is the return to an investor from holding the bond) and diversification.

S & P’s dividend yield and long-term US government bond yields are similar, making it difficult to justify holding bonds for carry. Regarding diversification, we believe that the lower bound of zero on yields skews the up / down potential of bonds. Put simply, bond prices may fall more than stock prices rise in risky scenarios and rise less than stock prices fall in risky scenarios.

Limited value, low carry and questionable diversification leave us little reason to hold bonds. We are fortunate not to have to fill a bond compartment or to emulate a benchmark and to be able to have low exposure to fixed income securities in our funds. Instead, we hold assets that are undervalued relative to their cash flow and offer diversification by behaving differently from traditional stocks. These include cash, gold, energy exposure, and a basket of cheap idiosyncratic companies. We believe they offer higher long-term yields than developed market bonds, as well as better yield and diversification benefits.

Mark Dunley-Owen is an analyst at Orbis.


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