What we think
With a continuing policy reliance on monetary “magic”, current financial repression in the form of negative (real) bond yields will continue for some time. Many central banks now own high shares of their countries’ overall debt (in the case of the Bank of Japan, 45%) and winding these holdings down will take time – if it happens at all.
The example of Japan provides a disturbing blueprint for European bond markets going forward – and maybe even for the U.S. in the longer run. It shows us that peak debt, ultra-expansionary monetary policy, direct intervention of the central bank into asset markets and hence low bond yields can continue for a very long time without bursting a bond bubble or causing a default of public debt.
Instead of waiting patiently for higher or positive bond yields, investors need to create a considered response to the current situation. Bonds with high ratings, in the past a source of stable and safe income streams, must now be seen from a different angle. They should still provide some diversification benefits in case of severe market downturns but need to be managed in a prudent manner.
What we suggest
Justify any holdings of non-yielding fixed income
- Make sure that the size of your allocation is appropriate and remember that a risk diversifier (one possible reason to hold non-yielding core government bonds) may not be an income provider.
Recognise that any return requires risk
- In the current environment, achieving any return on fixed income investments (with the exception of U.S. Treasuries) will require additional risk.
Consider the illiquidity premium
- To achieve higher returns, investors may need to accept restrictions on liquidity. Private markets in equity and debt may provide opportunities to capture illiquidity premia, but it is important to realize that such premia are not fixed and can move or even disappear over time.