While it‟s not something they‟ll want to hear, investors who are holding bonds for income will probably need to adjust their expectation of what bonds will deliver in the near future. In the short term, the healthy bond yields investors have come to expect over the last few decades aren‟t likely to return.
In this article, I look at why, until very recently, investors have relied on bonds as a solid source of income; why these factors aren‟t likely to deliver in the next three years; and what the options are for bond investors.
Why investors expect healthy bond yields
Although bond yields dived in 2008, and are now at historically low levels, they delivered good yields for a very long time before that. The 20 or so years before the global financial crisis (GFC) were an extraordinary time for bond owners. Not only did they benefit from solid yields, but also remarkable capital appreciation as yields gradually declined (as bond prices and yields move in opposite directions).
Many Australian investors consider a rate of 6% a natural floor for income from “safe” investments like bank accounts, term deposits and government bonds. They generally expect that even if income dips below that rate, it will soon rebound to this level.
Chart 1 shows why this belief is widespread. In the late 1980s, the Reserve Bank of Australia‟s cash rate (a key driver of short-term bond yields) and term deposit rates dropped from very high levels, and bond yields fell along with them. However, for the next 20 years, until the GFC hit, each of them hovered around 6%. Even after 2008 they rebounded for a few years, but have since had a slow decline.
What have been the main drivers of bond yields?
The key influence on the cash rate, and therefore on bond yields, in the last three decades has been the dramatic fall in inflation (see chart 2). In the early 1980s, the US Federal Reserve (the Fed) began a campaign to fight inflation, which was stubbornly high. Other central banks in the developed world joined in. Over the next two and a half decades, inflation declined not just due to the actions of central bankers, but also the increasingly de-unionised workforce, which forced wages down, and the opening up of China, which created a huge pool of cheap labour. This eventually enabled central banks to lower interest rates.
As interest rates fell, bond yields declined. Despite this fall, bonds continued to provide a healthy income of around 6% until the GFC. And because increases in the cost of living were falling with inflation rates, investors had some insulation from the decline in yields.
For example, in mid-1982, the US 30-year Treasury yield was 14.2% and the three-month Treasury yield was 13.5%.In 2007, they were still at 5.2% and 4.8% respectively. They‟ve now dropped to 3.4% and zero.
In Australia, bond yields followed a similar path. The yield on 10 year Treasury bonds fell from 16% in 1982 to 6.7% in 2007. It‟s currently at 3.7%, the lowest level on record.
Another factor that impacted bond yields was that for the “baby boomer” generation, the last three decades have been their peak period for accumulating savings. To achieve maximum growth, their investments and superannuation portfolios have usually been biased towards shares, with less exposure to bonds. This meant bonds had to offer reasonable yields in order to attract investors.
Why won’t bond yields bounce back fast?
Given the experience of the past 30 years, it‟s easy to think that bond yields are simply at a low point in their cycle and will quickly move back to around the 6% level. However, that‟s not likely to be the case in the next three years or so, as the outlook for inflation and interest rates are currently very different to the last few decades. There are also some emerging factors which may well keep bond yields low.
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