Bonds are generally included in an investment portfolio to provide diversification and generate returns. Developed market bonds currently offer much lower yields than their emerging market counterparts, but are perceived as less risky and therefore more popular. But is the safe option the best?
At Orbis, our investment principles include limiting the assumptions we make about the future and ignoring the short term. This is unusual for fixed income, where many investors rely on macroeconomic predictions for the next few months. Our investment philosophy, across all asset classes, including bonds, is the opposite of this thinking.
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Chart 1 is a remarkable reminder of why it is important to get the important things right. Shows the 10-year US government bond yield since 1970. Bond prices move in the opposite direction of bond yields, so consistently lower yields have resulted in consistently higher prices. high. An investor in US bonds in the 1980s needed to do something right, namely that inflation and therefore yields would fall, and maintain this conviction for the next 40 years.
This downward trend in yields has not been limited to US government bonds; Government debt yields in more developed markets have fallen to zero, and are negative for safe havens like Germany and Switzerland. Even Greece, which seemed likely to default on its debt obligations after the global financial crisis, now pays less than 1% on its public debt.
Corporate bonds have experienced similar performance compression, often regardless of underlying fundamentals. Bank of America’s High Yield Index in the US tracks US corporate debt rated below investment grade, more commonly known as junk bonds. Junk bonds yielded around 10% for much of the 1990s and 2000s. Investors were rewarded for taking “junk” credit risk. Today, in many ways in a more challenging period than the 2000s, these bonds offer a historically low nominal yield of 4% and a negative real yield.
Low returns mean fewer opportunities
Indiscriminate low returns pose a problem for long-term fixed income investors like us. Most importantly, unlike opportunities in Africa, low returns mean that there are fewer opportunities with an attractive likely return. They also negate two of the reasons we hold bonds in a balanced portfolio, namely to earn the carry (“the carry” is the return an investor gets from holding the bond) and diversification.
S&P dividend yields and long-lived US government bond yields are similar, making it difficult to justify holding carry bonds. In terms of diversification, we believe that the zero lower bound on yields skews the bullish / bearish potential of bonds. Simplistically, bond prices can fall more than stock prices rise in risk scenarios and rise less than stock prices fall in no risk scenarios.
Limited value, low carry, and questionable diversification leave us with little reason to own bonds. We are fortunate that we are not forced to fill a bond deposit or mimic a benchmark and we may have low fixed income exposure in our funds. Instead, we own assets that are undervalued relative to their cash flow and provide diversification by behaving differently from conventional stocks. These include cash, gold, energy exposure, and a basket of idiosyncratic and cheap companies. We believe these offer higher long-term returns than developed market bonds, as well as better yield and diversification benefits.
Mark Dunley-Owen is an analyst at Orbis.