Global bond yields are a threat and an opportunity
Amid sliding global interest rates emerging-market bonds offer good returns for long-term investors
In this time of extreme global market volatility arising from the threat of the Covid-19 pandemic, it would be remiss not to first urge South Africans not to panic — not in their behaviour towards others, not in their buying, and especially not in their investing. We have been through challenging times like these before and have proved that we are capable of overcoming the challenges thrown at us by global events, no matter how unusual.
There is no doubt about the tragic effect the virus is having on the lives of millions of people around the world, or its negative effects on the global economy as well as our own. The ultimate severity of any downturn can be gauged only as events unfold, but hopefully its impact can be mitigated by the measures governments around the world are taking now. Our government has declared a state of disaster to help slow the spread of the virus. At the same time the Reserve Bank implemented aggressive monetary stimulus last week in an attempt to mitigate the economic impact here. It is equally up to us all to do our part in stemming the extent of the crisis.
At Prudential we believe falling global interest rates and record low government bond yields in developed markets represent a considerable threat to global financial assets and investor returns for the foreseeable future. This has become an even bigger challenge in recent weeks as global government bonds have rallied even further as investors panicked by selling off equities and buying up bonds in the fallout from the coronavirus panic. Adding to this, central banks around the world, including our own, have unexpectedly lowered their benchmark interest rates aggressively in a bid to help mitigate the impact on economic growth.
Now most longer-dated government bonds across the world are offering negative real returns, meaning investors are willing to accept guaranteed losses for lending governments money over time. These assets used to be “insurance assets” to hold in retirement portfolios that paid you a steady, positive real return, but now could in fact be quite risky assets to hold.
What are the implications for investors’ global portfolios in future? Global balanced funds with a 60% equities and 40% bonds asset allocation — traditionally a broadly accepted split — will likely be challenged to produce solid, long-term inflation-beating returns compared with their history, even with lower inflation. The reason for this is simply that the 40% allocation to bonds has a starting yield of a negative return, so if these assets are held to maturity investors would earn negative real returns on a large part of the portfolio.
Passive products, too, may be challenged in this regard. Some very active trading will be needed to pick the correct bonds and end up with positive real returns over time. This does go against the established ideas of bonds as a relatively “safe haven” asset.
We have been avoiding global developed market government bond exposure, preferring to hold US and European corporate bonds and emerging-market government bonds instead. We believe the latter are especially well valued now after having underperformed their developed market sovereign counterparts in the past few years, even as their risk has broadly improved. This has come on the back of falling inflation, better governance, improved debt management and steady economic growth in many of these emerging markets.
We would also expect emerging-market inflation, which has previously been a substantial risk factor, to continue to wane, as it has in developed markets. Emerging-market bond yields should continue to gradually converge downward towards those of their developed market peers along with an ongoing drop in the variability of yields. This should lead to very attractive returns from these bonds over time.
The global production system under capitalism appears to be crushing inflation around the world over time, thanks to its adaptability and ever-improving productivity derived from innovation. For example, the data shows that current changes in the oil price affect core inflation very little in Organisation for Economic Co-operation and Development (OECD) countries compared with the 1970s and 1980s. Systems have adapted to absorb these changes much better.
Equally, the knock-on effect of exchange rate moves on inflation in emerging markets has also fallen over time. These trends are not as evident in SA today as in some other countries, such as Thailand, Taiwan, Poland and Chile. However, emerging-market bonds are likely to become better diversifying assets for investors over time, which also helps deliver good returns.
As such, today we are seeing current levels of government bond yields as both a threat (in developed markets) and an opportunity (in emerging markets) for long-term investors.
• Hugo is chief client distribution officer at Prudential Investment Managers.