As we have seen in a recent post (link to last bond post) the movements of the bond market during the last few months have been even more exceptional than the ones of the stock market, even if the latter often receive more attention from media.
The increase in interest rates that we saw recently came after a long period of at least 30 years of declining rates. After the inflationary Eighties, inflation was brough under control and a period of low and stable expected inflation followed. This produced declining interest rates around the world.
The non-conventional monetary policies that followed the great financial crisis known as Quantitative Easing, that consisted in large scale bond buying by central banks, also contributed to lift bond prices and to push interest rates lower.
What drives the direction of government bond market yields?
Usually, what drives the yield of government bonds depends on the maturity of the bonds. Short term government bond yields are closely related to the official rates fixed by the central bank. This means that the central bank has a certain control on the yield of short term government bonds.
On the contrary, long term government bond yields are driven more by supply and demand forces rather by the central bank policies. Long term bond yields depend more on long term economic and inflation expectations. The higher the expectations of economic growth and inflation, the higher long term bond yields.
The graph below shows the official rates decided by the Federal Reserve (in white), against the 2-year government bond yields (in blue), and the 10 years government bond yields (in red). The 2-year yield follows quite closely the official interest rates, while the 10 years yield can diverge.
Due to the high inflation, central banks have decided to step in and increase official interest rates. By making it more expensive for individuals and companies to finance themselves, the economy is supposed to slow down and the pressure on prices to fall.
So, yields at the short end of the curve (which, as we said above, is driven by central bank policy) have increased. The yield of the long-term bonds has also increased, but much less because higher interest rates are expected to slow down economic growth over the long term.
When the yields of short-term bonds increase more than the ones of the ones of long-term bonds, the yield curve (the curve that connects the yields of bonds for different maturities) is said to flatten. Actually, if we look at the US Treasuries yield curve, it has even inverted, meaning that it has become negatively sloped. The graph below represents the curve today (in orange) vs how it was one year ago (in grey).
The graph below shows the government bond yield increases of different maturities in the US during the last one year.
*The reason we are considering especially the US is because the Federal Reserve seems to be leading the other central banks in this tightening cycle.
What drives the yield of bonds issued by corporates?
We have seen what drives the yield of bonds issued by governments. For the bonds issued by corporates, there is another factor to consider. Investors in this kind of bonds will in fact usually require an additional return compared to the one of government bonds of the same maturity to be compensated for the higher risk that the issuer might run into financial problems and will not be able to repay its obligation. This is known as the risk of default of the issuer.
Corporate issuers usually have a higher risk of defaulting than governments, so the pricing of their bonds will incorporate a certain premium for this risk in terms of additional yield. The premium in terms of yield above government bonds of the same maturity is called credit spread.
Corporate bond yield = default free government bond yield + credit spread
This spread is not fixed over the life of the bond, but varies with the perceived likelihood of default. When the economy slows, the likelihood that a corporate might default on its obligations increases, and so does the spread. A higher required spread increases the yield of the corporate bond and pushes the price lower.
This is what usually what drives bond prices lower during economic downturns and makes them positively correlated with the stock market.
Usually, when corporate bond spreads widen because of an increased perceived likelihood of default investors tend to flight to bonds that are considered safe such as government bonds, pushing their price higher and their yield lower. So, government bond yields and corporate bond spreads tend to move in opposite directions.
It was not the case this time, as government bond yields went higher together with credit spreads. Government bond yields went higher because of higher inflation, and credit spreads increased because the current increase in interest rates is expected to slow down the economy and possibly cause a recession.
This is coherent with the fact that also stocks and government bonds moved in a correlated way.
The graph below shows this dynamic. The blue line is the yield of the US corporate bond’s High Yield that is given by the sum of the yield of a Treasury bond (in green) plus a corporate bond spread (in red).
Let’s look at how different the current situation is from 2020 for example. In that case, all the increase in High Yield corporate bond yields was given by an increase in credit spreads, while the flight to quality pushed government bond yields down.
Today, government bond yields and corporate spreads are increasing together.
In terms of absolute yield, the current level is quite high and similar to previous crisis period. Credit spreads are however not as high as in previous occasions, as if a possible recession were not fully priced yet. The increase in corporate bond yields has been driven until now especially by the increase in risk-free rates.
* In the graph, Treasury yield and HY credit spread may not add up perfectly to make the HY corporate bond yield because we use the 5y Treasury yield that might not match exactly the maturity of the HY Index. It is a good approximation anyway.
What’s next for bonds?
Certainly, the times when there was no alternative to investing in stocks seems to be over. The yield of government bonds is at levels not seen since before the great financial crisis of 2008. A two-year US government bond now has a yield of around 4.5%. The yield of HY bonds is around 9.5% in the US and 8.5% in Europe.
Certainly, we are not out of the woods yet, but these yearly returns accrue each year to investors, and they can even amortize possible further pressures in prices. Just to make an example, a 9% yearly yield would be able to compensate the negative effect of a further increase of 2-2.50% in yields over one year.
If expectations of an economic slow down are correct, it is likely that government bonds yields will slow down their increase and eventually will start to fall. This is especially the case in the US, where we can say that the cycle of interested rates cycle started earlier and is now at a more advanced stage. So, government bonds will become interesting again.
What about corporate bonds?
As we mentioned above, corporate bond spreads tend to be negatively affected by a slowing economy, so the pressure on spreads could persist. Current yield levels anyway are quite interesting. Even if you do not want to take the risk of investing in high yield low quality names, now even good issuers offer a 5-6% return which is certainly worth considering.
So, all in all, certainly we are witnessing a change in regime in global interest rates that could be painful for bonds as higher interest rates tend to push lower the price of bonds in circulation. The huge amount of global debt that is being repriced on the basis of higher yields certainly is not easy to absorb for investors that see decreases even in the value of the most prudent portfolios.
Over the medium-long term anyway, these level of returns seem to become interesting again after years of anormality with interest close to zero or negative. This could bode well for expected returns of diversified portfolios that during the last few years got very little benefit from the bond component.
