It's Dangerous Out There in the Bond Market

Is There New Investor Concern About Bonds?
  • Investors face damaging losses if yields rise even a little
  • A half-percentage point increase would wipe out $1.6 trillion

Bond investors are taking bigger risks than ever before.

Yields on $7.8 trillion of government bonds have been driven below zero by worries over global growth, meaning money managers looking for income are pouring into debt with maturities of as long as 100 years. Central banks’ policy is exacerbating matters, as the unprecedented debt purchases to spur their economies have soaked up supply and left would-be buyers with few options.

While demand has shown few signs of abating, investors are setting themselves up for damaging losses if average yields rise even a little from their rock-bottom levels. Based on a metric called duration, a half-percentage point increase would result in a loss of about $1.6 trillion in the global bond market, according to calculations based on data compiled by Bank of America Corp.

This year alone, the danger of owning debt has surged by the most since 2010, raising concerns from heavyweights such as Bill Gross. It’s also left some of the world’s biggest bond funds, including BlackRock Inc. and Allianz Global Investors, at odds over the benefits of buying longer-dated bonds.

“It takes a fairly small move out in rates on the long-end to wipe out your annual return,” said Thomas Wacker, the head of credit of the Chief Investment Office at UBS Wealth Management, which oversees $2 trillion in assets. Longer-maturity debt is “not something we are particularly keen on,” he said.

Investors continuing to buy bonds even when they pay next to nothing suggests deep concern over the state of the global economy. This month, the International Monetary Fund warned the threat of worldwide stagnation was rising because economic expansion has been so tepid for so long. It also chopped its 2016 growth forecast to 3.2 percent from 3.4 percent in January.

BOJ, ECB

That gloom, combined with more aggressive stimulus measures by the Bank of Japan and the European Central Bank, pushed average yields on $48 trillion of debt securities in the BofA Merrill Lynch Global Broad Market Index to a record-low 1.29 percent this month, compared with 1.38 percent currently.

It won’t take much of a backup to inflict outsize losses.

The effective duration of the global bond market, which is measured in years and determines how much prices are likely to change when interest rates move, surged to an all-time high of 6.84 years in April. That translates into a 6.84 percent decline in price for every percentage-point increase in yields.

Economists suggest the bond market is underestimating the potential for yields to rise, especially as the Federal Reserve considers raising rates. The median estimate in a Bloomberg survey calls for the Fed to boost rates twice in 2016, while traders see the chances of any increase this year at about 60 percent.

‘Complacent’ Investors?

“People are complacent,” Fabrizio Fiorini, chief investment officer at Aletti Gestielle SGR SpA, which oversees more than $17 billion, said from Milan. “Time is against the long end of the bond market. Even if an increase in bond yields may not be so strong, the positions are so huge that the damage can be massive.”

While the implied risk of holding bonds has been building for some time, it surged by the most in more than five years in the first quarter. A big reason for the jump has been increasing demand for long-dated issuance, which has proved a boon for governments that have locked-in borrowing costs for generations. In April, France issued a new 50-year security for the first time since 2010, while Ireland sold its first ever century bond in March.

Last week, Argentina had little problem finding buyers for its first debt sale since its record $95 billion default in 2001, which included a 30-year maturity.

“We are happy to feed the market with the product they want,” said Anthony Requin, the chief executive at Agence France Tresor, which raises money from bond sales for the French government.

Century Bonds

Although longer-maturity issues have provided investors the opportunity to reap bigger returns, their yields are still rather low by historical standards. Ireland’s 100 million euros ($113 million) of bonds due in 2116 were issued to yield 2.35 percent -- similar to yields that benchmark 10-year German bunds offered as recently as 2011.

The yield on German 10-year bunds has now slipped to about 0.26 percent, dragged lower by the ECB’s program of bond-buying, which was expanded to 80 billion euros a month in March. Meanwhile, in Japan, all of the nation’s sovereign bonds yielded less than 0.4 percent last week, a result of the surge in the securities since the BOJ introduced a negative interest rate earlier this year.

Such low yields are unnerving some of the most famous names in the bond market.

Gross, who runs the $1.3 billion Janus Global Unconstrained Bond Fund, said in a recent tweet that a tiny move in Japanese 30-year government bonds could wipe “out an entire year’s income.”

When gains last year pushed benchmark German 10-year yields close to zero, Gross described them as a “short of a lifetime.” That was in the early stages of a selloff which pushed yields up by more than a percentage point in less than two months.

Richard Turnill, the global chief investment strategist at BlackRock, the $4.7 trillion money manager, also said the firm expects losses for long-dated U.S. Treasuries and euro-area debt over five years, while Japan’s biggest life insurers are looking for higher returns in corporate bonds and infrastructure lending in the year ahead, as central bank stimulus clouds the outlook for sovereign debt at home.

Opposing Views

Some investors like Allianz Global Investors see it differently. They expect yields of ultra-long bonds to keep declining as weak growth spurs more monetary easing in Europe and Japan and keeps the Fed from raising rates.

“The price of these bonds increase at an accelerating rate,” said Brian Tomlinson, Frankfurt-based global fixed-income manager at Allianz, which oversees about $500 billion, referring to the market’s longest-term issues. “Economic growth continues to disappoint globally.”

Tomlinson said Allianz snapped up the French 50-year bond when it was offered and then bought more once it started trading. The firm is also “overweight” 30-year Treasuries and U.K. gilts. Prudential Financial Inc. predicts yields on the U.S. 10-year note will fall to a record 1.25 percent. If that comes to pass in three month’s time, investors will reap an annualized return of 26 percent, according to Bloomberg calculations. The yield was at 1.90 percent as of 2:30 p.m. in New York Monday.

Even so, some remain reluctant to buy securities which offer such meager returns.

“There isn’t a lot of value in the long-term debt,” Jim Leaviss, a London-based manager at M&G Investments, which oversees about $374 billion.

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