INVESTOR EDUCATION – Higher Bond Yields & the Risks
Over the past month there appears to have been a fundamental shift in the approach central banks have
had in relation to their interest rate policies. We have now heard from a number of the largest central banks
including the Bank of Japan (BOJ), the European Central Bank (ECB), Reserve Bank of Australia (RBA),
Reserve Bank of New Zealand (RBNZ) and arguably the most important, the US Federal Reserve (Fed). The
consensus from the majority of central banks has been that interest rates are approaching or have
approached their low point. In addition, there appears to be a shift away from the belief that lower rates
are better for the economy and the realisation that negative/near negative yields creates a real conundrum
for both the investment community and the banking sector.
The change in sentiment is important. Although it is still at its early stages it suggests that global yields may
have reached their lows and accordingly the direction from here is likely to be higher. Although this will be
welcomed news for retirees and savers, higher lending costs are likely to have large and possibly detrimental
effects for borrowers and leveraged equity investments (companies with high levels of debt). Accordingly,
believe it is important to understand recent events in context and attempt to understand what this
may mean for the wider investment universe.
Are the tides turning?
Since the 2008 Global Financial Crisis (GFC) Central Banks have cut interest rates and
pursued easy and accommodative monetary policy in an attempt to boost confidence
and support growth.
Low interest rates are designed to promote growth by supporting business by allowing
them to borrow at lower costs and thereby up take high growth projects that maybe
not have been as profitable at higher costs. When company’s uptake growth
opportunities, it generally means higher economic employment and consequently
higher income for the economy.
In addition, lower interest rates generally correspond to a fall in the countries exchange
rate. The interest rate differential suggests countries with relatively lower interest
rates have weaker currencies. A lower exchange rate is also supportive of growth given
that it makes goods and services produced by that country relatively cheaper
compared to their global competitors and therefore correspond to increased demand.
Global 10 year Bond Yields
In addition to cutting benchmark interest rates, a number of central banks have also
pursued quantitative easing. This is where the Central Bank/Treasury enter the market
and buy back their own bonds in an attempt to lower interest rates further. This policy
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is pursued when the benchmark rate is already close to or at 0% and therefore the
Central Bank has limited ability to decrease their yields further.
The table above illustrates that absolute change in interest rates from the start of 2008
to today’s levels. It is evident that interest rates have fallen materially over that time
as a result of monetary policy conditions that Central Banks have installed outlined
above.
However, recently there has been a shift in sentiment. Central Banks have adjusted the
wording in their policy statements and have indicated that they are prepared to allow
interest rates to rise.
We believe that there are two major reasons for this change. Firstly, the global
economy is slowly improving and there are tentative signs that growth and inflation is
beginning to return. Secondly, it appears Central Banks have come to the consensus
that lower interest rates are not always good thing and actually present their own
challenges. Sustained periods of low interest rates make it extremely difficult for
pension funds and the banking sector to function correctly.
Pension funds are currently being crowded out of being able to invest member’s money
into assets that generate enough return for retirees to live off. With global bond yields
so low, and in combination with Central Banks repurchasing their own bonds, pension
funds have very little opportunity to invest their funds into attractive assets. This is
forcing them into more risky asset classes and investments in order to generate
acceptable returns. Essentially by Central Banks pursing the policies outlined above
they are making the financial system riskier instead of making them safer as intended.
Furthermore, the banking sector has also suffering from low and flat interest rate yield
curves. Traditionally banks earn money from borrowing at a short duration at low
interest rates and lending to borrowers for a longer duration and higher rates. The
spread between short term interest rates and long term interest rates was essentially
the banks profit. However, with policy rates so low, and some even negative, banks are
unable to earn meaningful profits from their traditional methods. Accordingly, without
the ability for banks to make profits, some have questioned their reason for existing.
However, banks sever an important service and the wider economy benefits from
banks’ ability to extend credit and finance economic activity. Consequently, Central
Banks would not want to see banks shut due to an inability to make sufficient profits.
Although changes are still very early and accordingly the shift in sentiment tentative,
below we outline a number of key reasons why we believe a systematic shift from the
world’s largest Central Banks is under way.
Bank of Japan (BOJ)
The BOJ as openly admitted that they have crowded out their pensions funds ability to
purchase bonds and have depressed their bond yields to unreasonable levels.
Accordingly, they are steeping back from committing to purchasing a specified amount
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of their own bonds, but rather focusing on controlling interest rates to more
reasonable levels.
The Bank of Japan Gov. Haruhiko Kuroda said that the central bank “will not hesitate”
on monetary easing if necessary but the moderate recovery of the Japanese economy
does not warrant such action now.
Furthermore, if interest rates fall deeper into negative territory, it “could have a
negative impact on the profitability of the financial system” or banking profits,
although it “could have a stronger, positive impact on the real economy,”
European Central Bank (ECB)
Comments from ECB officials in recent weeks has suggested that the central bank was
in no immediate hurry to address a scarcity of eligible bonds for QE or extend the
programme have added to a sense that ECB policy is nearing the end of its
effectiveness. Accordingly, this lead to speculation that the ECB would probably wind
down the monthly 80 billion euro ($90 billion) quantitative easing (QE) scheme
gradually in the near term future. Janus Capital tweeted its fund manager Bill Gross,
one of the best-known names in the bond market, as saying on Tuesday: "ECB taper
tantrum underway. Bearish for global bonds."
US Federal Reserve (Fed)
The Fed ceased its quantitative easing’s in October 2014 by ending its bond purchases
and the focus then became on increasing its benchmark interest rates. Since then we
have had 1 interest rate hike and policy makers indicated that they believe that 1 more
interest rate hike this year is likely to be required (most likely in December this year).
More hikes are likely to be needed in 2017 and 2018 albeit gradually. The important
point is that projector of interest rates is up not down moving forward.
What it could mean for you
Equity prices- particularly leveraged equities come and income stocks come under
pressure
Increased borrowing costs- implications on the housing sector
Higher savings rates
Opportunities
There are major dangers to interest rates falling so low. Firstly, Central Banks use
interest rates to control the speed of their economies. They increase interest rates
when inflation and growth are high and lower rates when lower rates when the
economy is in need of a boost. However, when interest rates are already at zero, it
removes an important tool in their arsenal and prevents them from lowering interest
rates in response to a slowing economy. Consequently, Central Banks have to look for
alternative and less effective measures to try and combat economies hurdles.
Low interest rates also promote companies and individuals to borrow excess debt.
Because interest rates are so low, inefficient business are able survive and borrow
more. However, as interest rates climb they are no long able to service the debt
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repayments and consequently end up failing on larger amounts of debt than what
would have occurred in a “normal” environment.
Finally, the sharp decline in yields increases the risk of sharp asset price corrections
and increases in unwanted volatility. An unexpected event could set off a stampede
for the exits in government-bond markets leading to an unorderly collapse of the bond
market. This can lead investors to suffer large capital losses which otherwise could have
been avoided.
The tumbling yields have been rippling through markets in an idiosyncratic fashion.
Investors are being forced to find yield where they can and this has resulted in a flood
of investor funds moving from the bond market into equities.
High dividend stocks are in vogue and the increased demand for equities has caused
equity valuations to become stretched. As with the bond market, an overvalued equity
market can also be at risk of sharp and fast corrections. Complacent investors can easily
be caught out and suffer capital losses as a result. Australian and New Zealand stocks
offer relatively high dividend yields against the global benchmark and therefore receive
additional demand in low interest rate environment.
The switch in asset classes from bonds and into equities has pushed equity markets
to all-time highs despite economic growth remaining below trend. It is a rather
perplexing enigma when equity markets continue to push to record highs, yet
underlying growth remains subdued.
Despite bond yields continuing to make new lows it is important to bear in mind the
larger picture at play. As markets and particularly global interest rates become more
and more preplexing the risk of a market melt down increases.
Overtime, long term fundamentals override short term fluctuations and trends.
Interest rates at negative levels can not persist indefinitely and we believe it is
leading to a hightened risk of a market crash. We caution investors not to get caught
up in crowded trdes in the “hunt for yield” and instead focus on tangible valuations
and economic dynamics which will drive valuations overtime.
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