The return of higher yields marks the end of an era
The film “The return of the Jedi marks the end of an era” suggests the conclusion of a significant period of time. Similarly, the current bond market marks the end of an era in which central banks pushed interest rates to 0% and expanded their balanced sheets through the implementation of Quantitative Easing (QE). Just as in the famous George Lucas’ trilogy, there are two key events in the bond market that preceded this new era: The Great Financial Recession in 2008-09 and the Covid19 pandemic, both of which led to extremely lax monetary policies.
Now, inflation has returned to our daily lives and central banks are normalising monetary policy. As a result, bond yields across all the spectrum have increased significantly to levels that are attractive again. Unfortunately, the bond index displayed in the chart lost 15% during 2022.
The chart shows the Yield To Worst (YTW) of the Bloomberg Global Aggregate Baa Index Hedged to USD. We can identify two main points:
- During the period from 2013 to 2021, when central banks significantly relaxed monetary policy, these bonds yielded an average of 2.6% in USD. When hedged to EUR, this yield was lower than 1% and when hedged to CHF, it was close to 0%. During this “era” it was difficult to achieve decent returns in the conservative portfolio of fixed-income securities, especially in EUR or CHF.
- As of today, in this “new era”, we can invest in liquid Baa securities that yield 5.3% in USD (when hedged to EUR, around 4.1%; when hedged to CHF around 3.1%). This makes this asset class attractive again, as it was in 2010-11-12.
A savvy investor might point out that with US headline inflation at 7.1%, bond investors are certain to lose purchasing power before taxes, and lose even more after taxes. However, a further analysis of inflation shows that break-even inflation predictions for the next 7-10 years suggest price increases of around 2.2%. This means that we would gain 3.1% in real returns investing in relatively secure Baa bonds (BBB using S&P ratings) with average maturities of 8.9 years and a duration of 6.2 years.
SO, WHAT CAN WE EXPECT IN THIS “NEW ERA” FOR BOND INVESTORS IN 2023?
- Case 1: Bond yields remain stable at these levels: Expected return 5.3%.
- Case 2: Inflation is worse than expected and central banks tighten more than expected, causing the YTW to increase from 5.3% to 6.3%. Expected return -0.9%.
- Case 3: Inflation follows the expected path and cental banks become less hawkish or dovish, causing the YTW to decrease from 5.3% to 4.8%. Expected return: 8.4%
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