Updated: May 19
In my last blog I wrote about how volatility is a poor measure of risk, by considering the general attributes of both equities and bonds. In this blog I look in more detail at the risks associated specifically with bonds, concluding that returns over the next decade or two will almost certainly be impaired by negative interest rates and possibly higher inflation too.
"Poundland would be able to change its name to 37 Pence-Land"
There are four types of negative risk associated with any bond:
Credit risk – the risk that a bond issuer will default before a bond reaches maturity
Inflation risk – the risk that bond returns will be impaired by rising inflation expectation
Interest rate risk – the risk that a bond price will fall because of rising interest rates
Currency risk – the risk that the currency in which a bond is denominated falls
Each of the above risks also have a positive counterpart. For example, the perceived probability that a bond will default may fall rather than rise, causing the bond’s price to rise. And expected inflation may fall, enhancing rather than impairing a bond’s return. Different types of bond are subject to these risks to varying degrees.
For example, the main risks impacting long-dated gilts (for a sterling based investor) are inflation risk and interest rate risk. On the other hand, emerging market high yield bonds will be subject to currency risk and credit risk, and to a lesser extent interest rate and inflation risk (corporate bonds tend to have shorter maturities than government bonds so on the whole are less impacted by interest rate and inflation risk).
Let’s first take a trip back in time to 24 January 1986. This was the day the British government issued £1 billion of 17 year Gilts at a yield of 10.83 per cent. Thus the total return if you bought at issue and held to maturity was 474.35 per cent. Now, from end January 1986 to end January 2003, consumer prices as measured by the retail price index rose by 85.35 per cent so your real return would have been 209.87 per cent (one calculates the geometric not the arithmetic difference). This is equivalent to 6.88 per cent per annum over the 17-year life of the bond, not bad for lending to a highly credit worthy government.
Before we proceed, a quick tutorial for those who need it about “straight” bonds and inflation-linked bonds. If the yield of a one-year gilt is 10 per cent and the yield of a one-year inflation protect gilt is 6 per cent, the difference between the two yields is known as the breakeven inflation rate (in this case 4 per cent). This is the rate of inflation at which the returns (real or nominal) will be the same for both. If actual inflation over the year turns out to be higher than 4 per cent, the return from the “straight” gilt will be lower than that from the inflation-linked gilt (if lower then higher). End of tutorial.
Fast forward 30 years to today. The best estimate of what your total real return will be from “straight” Gilts can be found in the inflation-linked market. Currently, the 20-year inflation protected Gilt is yielding -0.86 per cent. This is considerably worse than the aforementioned +6.88 per cent achieved from 1986 to 2003. The difference is a massive 7.74 per cent per annum or 344 per cent over 20 years.
Furthermore, the current 20-year breakeven inflation rate is 2.93 per cent (the current 20-year “straight” bond yield is 2.07%), so if actual inflation over the next 20 years is higher than 2.93 per cent, your real return from a 20-year gilt would be even worse than -0.86 per cent per annum. For your real return to be similar to the 6.88 per cent achieved previously, actual inflation over the next 20 years would need to average approximately -5 per cent per annum.
To put this in perspective, in 2036, Poundland would be able to change its name to 37 Pence-Land. Never before has there been anything close to deflation of this order. The worst 20-year period of deflation was from 1317 to 1337, when consumer prices in the UK fell 42 per cent (this was related to the Great Famine of 1315-17 and other natural disasters that followed soon after). This is far cry from the 63 per cent fall that would be required to give you a 6.88 per cent per annum real return from bonds over the next 20 years.
The conclusion is this: if you are relying on bonds to provide real returns even half that of decades past, you are sorely misguided. That is the problem with negative long-term interest rates.
To end on a really low note, the real return from Gilts could be even lower than that which the current -0.86 per cent inflation-linked yield implies if actual inflation is higher than the 2.93 per cent currently expected. Those who remember the late-1960s and 1970s will know all too well how easily this can happen.
Published in Trustnet
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.