One notable side effect of the bond ‘rally’ is the increase in duration, which has created significant risk as and when yields increase (take for example the +45bp yield move between late August and early November 2019 which caused some long dated bonds to drop by as much as 20%). Today, risk is being shifted towards so-called risk free assets, where potential losses will be higher due to the impact of duration and where volatility is structurally higher. This significantly reduces the Sharpe ratios of risk-free assets, rather than those of risky assets. By way of example, Bund bond prices have been much more volatile than High Yield bonds.
The yield spiral is another side effect of a low/ negative world. Investors are caught in the spiral - forever chasing that extra yield, driving yields lower and increasing the pool of negative-yielding bonds. This pushes many to move outside of their comfort zone into alternative, but less-liquid, asset classes. Assets from private markets have become a key investment alternative to public markets and the size of this market is at a formidable USD 5.8 trillion.2 If global growth slows into 2020, as we and many others expect, risky assets are likely to underperform and withdrawal pressures are likely to drive losses in this illiquid sector.
Lower rates have also had a dramatic effect on pension schemes, which are grappling with growing liabilities due to the fall in rates and ever-diminishing returns of their assets. Many pension funds are now facing the unpalatable prospect of having to reduce pay-outs (for example in the Netherlands), as the expected rates of return on bonds have dropped (this effect has been compounded by the fact that they were forced to hold more bonds and less risky assets for liquidity and risk reasons). A similar problem is facing many life insurers, especially in Germany where they have sold yield-guaranteed products where the underlying asset yield does not meet the guaranteed yield.
As yields have fallen, listed companies have been more eager to borrow money in order to reward shareholders via dividends and buybacks. This has fuelled the rise in global stock markets, whilst also driving up leverage in many company balance sheets. In fact, US BBB and Single B company leverage (net debt to EBITDA) is now at a 10-year high. On any economic slowdown, earnings will fall further, fuelling leverage and driving more rating downgrades. This is a key risk, given that the US BBB sector accounts for 57% of the IG US credit market.3
One final point to mention is the disruption to the fund industry. With listed equity asset valuations near their highs and bonds paying near zero or negative yields, we have witnessed an outflow from more expensive actively-managed funds into cheap passive funds and ETFs. In the US, equity ETFs’ assets under management (AUM) are now larger than the AUM of actively-managed equity funds. Given the easy accessibility to financial markets that ETFs create, many retail investors have direct access to trade assets that in the past were the domain of professional investors alone. While this may not be a problem in a bull market, it creates an asymmetry in a bear market where the risk of panic selling by ETF holders is a distinct reality, thus exacerbating volatility.
In summary, the drop in global government bond yields is a sign that risks are increasing in global markets. Whilst central bank policy has so far averted a recession, further weakening of the economy or a rebound in yield due to an improvement in the economy is likely to push volatility higher
Can rates rebound off these low levels? Yes they can, but we cannot see a case for yields increasing back up to 1980 levels, let-alone 2000 levels, as there are enough key structural factors keeping rates down, i.e. globalisation, ageing populations and regulation:
- Globalisation has enabled companies to reduce their costs via outsourcing production, thereby creating downward pressure on inflation.
- People are living longer, and hence need to save more in order to better plan for expenses as they get older.
- Finally, regulation and capital requirements have further increased the demand for safe assets, with banks having to hold substantially-larger levels of capital and liquid reserves.
1 CIOs evaluate risks of bond negative yields Financial Times Sept 8 2019
Over half of euro zone government bond yields now below zero, Reuters, June 20 2019
2 Private Debt in 2019, Preqin, Sept 2019,
Private markets come of age, McKinsey&Company 2019
3 BNP Paribas analysis