Yields need not be a killjoy

Investors in safe government bonds will have to get used to negative yields. This is not an attractive prospect, given the possibility of positive returns on riskier investments, including various bond segments. Playing the role of safety buffer in a portfolio seems to be over for European government bonds.


03/06/2021 – Chris Huys

Last year, central banks shied away from further experiments with serious cuts in already negative interest rates: they opted instead for massive bond purchases to keep interest rates down. Central banks now play a significant supporting role in keeping the money press going. But governments have now taken the lead, rolling out vaccines and 'budget bazookas'. One of the absolute key players among central bankers, Mario Draghi, now actually holds a government post as Italian prime minister. He leads a government that will play a crucial role in sustaining the European recovery.

Credit risk should not be a major concern in the current environment, with governments finally able to release the economic brakes and accelerate fiscal stimulus. However, it is wise to remain vigilant for corporate issuers that are still too close to the abyss or even over it.

The main concern at the moment is the upward creeping of risk-free rates on safe government bonds, which are still negative in Europe. Stubbornly low inflation and a resolute European Central Bank are expected to quell these concerns in the year ahead, providing support to bond markets across the board. Since investment-grade bond yields are still negative on average, a fall in yields will often be needed to generate positive returns.

However, against a background of exuberant economic growth and yawning budget deficits, falling yields are anything but usual. Investors will have to be convinced that, as in the past decade, inflation will not become a problem. For now, the actual inflation figures, on which central bankers, by default, also set their policy compasses, still contain too much 'noise' to provide clarity.

In the second half of this year, investors may start to realise that inflation expectations, which have been rising for a year, have now been exaggerated. This prospect is clearer for Europe than for the US. The US is ahead of Europe in vaccinations – but it is mainly the fiscal impulse that will be much stronger in the US than in Europe. As a result, interest rates in the US have already risen much further than in Europe, a difference that does not look likely to be reversed for some time. On balance, we expect safe sovereign yields in Europe to remain negative for the time being. And we do not expect higher yields on US government bonds in the coming months.

For the time being, a positive return on bonds requires a substantial risk premium for investors. The risk premiums on investment-grade corporate bonds, but also on high-yield and emerging-markets bonds, are historically low, but not extreme given the favourable outlook and low credit risks. These bond segments therefore offer the best opportunities for investors.

Risk premiums on peripheral eurozone government bonds still offer a passable path out of the morass of negative interest rates. The majority of European countries have been driven by the coronavirus crisis into the same boat as Italy and Greece in terms of government budgets. In this way, European solidarity is now being enforced after all.

Chris Huys – Senior Fixed Income Portfolio Manager

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