Real Bond Yields Likely to Stay Dismal

by Levi Folk | October 23, 2006

We are entering an environment of wealth preservation rather than one of capital accumulation for bond investors. Expected returns should be lowered for domestic and foreign bonds, but investors should not abandon the asset class altogether for reasons of diversification and lesser still for expected returns.

When the leading bond fund manager in Canada tells you, as happened recently, that his modus operandi for his bond fund—a double-digit performer, no less, over the past seven years—is changing from return generator to capital preserver, you would be wise to listen.

The present-day reality is that low absolute yields for government and corporate bonds globally, having reached multi-decade lows in 2003, leave little room for further capital gains.

That said, investors should still hold bonds because it is unlikely that we are heading into a period of high inflation, a repeat of a 1970s-style oil shock if you will, that turned bonds into destroyers of capital throughout that decade. The reason is twofold: central banks are credible inflation fighters now and china and its industrializing neighbors are exporting deflation.

Nineteen-seventies bond investors, caught looking backward not forward, walked into a wall of inflation precipitated by the OPEC oil shock that led to double-digit rises in consumer prices. In 1971, 10-year U.S. government bonds offered a 5% annual yield much like they do today. A decade later, when a US$100 face value bond matured, investors were left with only US$65 of purchasing power, a real (inflation-adjusted) loss of principal of roughly 35%.

The U.S. Federal Reserve Bank accommodated inflation by keeping monetary policy loose in the face of stagflation, that is, economic recession and inflation, which was the wrong policy response to the supply-side shock. These days, central banks are better equipped to deal with such supply-side shocks, judging by the 19 consecutive rate hikes orchestrated by the Fed in recent years, notwithstanding the spike in the oil price to over US$75 per barrel.

But perhaps the biggest factor underpinning low inflation and a stronger bond market is the apparent lack of pricing power for manufacturing labour in the industrialized world. The United States is importing deflation from China as the prices for manufactured goods continue to fall. Import prices from non-industrialized countries have been falling in the United States over the past decade.

The wage gap for manufactured goods between labour in China and the United States undermines labour’s bargaining power in the developed world. Moreover, the accession of former eastern-bloc countries to the European Union means that labour mobility will continue to keep wages soft in European manufacturing.

Low absolute yields are the problem for bond investors. Ten-year yields in the United States, at roughly 5%, are near 30-year lows. With little room for yields to fall further, returns will be limited. Factor in inflation and the real yield for bond investors is dismal. Hence, bonds are becoming vehicles for capital preservation.

That said, investors should not abandon the asset class wholesale in the search for yield. With inflation under control, bonds will likely offer stable single-digit returns over the foreseeable future. And they offer important diversification to long-only equity portfolios.

Structured products are gaining in popularity as fixed-income replacement vehicles because some offer the allure of principal protection and shorter terms to maturity. That is all well and good in so far as investors are exchanging one form of capital protection for another.

However, principal-protected notes also tend to be linked to equity-market returns and pay a variable return associated with the performance of an underlying equity basket. In this case, investors should be aware that they are likely taking on equity risk in search of yield.

Investors are therefore left with little choice but to suck it up and stay invested in the fixed-income asset class. Bonds will serve as a means to protect the purchasing power of money, the assumption being that inflation will remain under control for the foreseeable future.