Global Bonds: A World Without Yield

Key Points

  • Near- or below-zero bond yields in major global markets are likely to persist into the second half of the year, due to soft global growth, central bank buying and strong investor demand for bonds.
  • However, we doubt the strong performance year to date can be repeated in the second half of the year, especially in the riskier areas of the fixed income market. With yields low and prices high, bonds are susceptible to setbacks.
  • Investors with exposure to international and low-credit-quality bonds may want to re-examine the allocations within their fixed income portfolios, as risks are rising and the potential rewards are declining.

The plunge in global bond yields intensified during the past month. While short-term interest rates have been less than zero in some markets for quite some time, longer-term bond yields have recently fallen back to the zero level. Ten-year Japanese government bond yields are already in negative territory, with major European yields nearing the zero mark. Overall, record-low yields have been reached in Japan, Germany and the U.K., and Fitch Ratings estimates that more than $10 trillion in government bonds now have negative yields.

10-year bond yields have fallen in the U.S. and other developed economies

Source: Bloomberg, monthly data as of 6/6/ 2016. Note: Year-end average yield represents an equal-weighted average of each country's 10-year government bond yield at the close of each calendar year listed, except for 2016, which is as of 6/10/2016. Past performance is no guarantee of future results.

Contributing factors

Global bond yields are declining against a backdrop of factors including slowing economic growth, central bank buying and strong demand for bonds (remember that bond yields move inversely to bond prices). Let’s take a look at some of these contributing factors:

1. Central bank buying has reduced bond supply

Aggressive central bank bond purchases are a significant factor in the recent drop in bond yields. As a result of its quantitative-easing programs, the Federal Reserve has over $4 trillion, or about 24% of gross domestic product (GDP), in bonds on its balance sheet. The Fed estimates this has reduced long-term interest rates by about 75 to 100 basis points.1 The Bank of Japan (BOJ) holds the equivalent of 83% of Japan’s GDP on its balance sheet, and continues to buy more assets.2 Most recently, the European Central Bank (ECB) has stepped up its purchases of bonds. Having nearly exhausted the supply of government bonds it can buy, the ECB is now buying corporate bonds in an effort to reduce financing costs for companies, hoping this will stimulate economic growth.

Assets of central banks as a proportion of GDP

Sources: National statistical agencies and central banks via the Federal Reserve Bank of St. Louis, European Central Bank, Statistics Bureau of Japan (Ministry of Internal Affairs and Communications). Monthly data as of April 2016. Assets are calculated as percentages of quarterly GDP; generally there is a one-quarter lag between assets and GDP.

2. Supply has fallen amid growing demand for yield

On the demand side, investors with long time horizons are scrambling to find positive yields. Investors such as pension funds and insurance companies, which are obligated to pay distributions in the years ahead, need long-term assets to generate income. Not surprisingly, they are more inclined to buy positive-yielding bonds than those with negative yields. Consequently, demand for riskier bonds has been strong. In addition to falling European corporate bond yields, there has been a decline in yields in “non-core” European countries, such as Portugal, and emerging market bonds, including local currency bonds. The difference in yield between EM local currency bonds and the Barclay’s U.S. Aggregate Bond Index is at the narrowest level since 2010.

Difference between the Barclays Emerging Markets Local Currency Government Index yield and the Barclays U.S. Aggregate Bond Index yield

Source: Barclays, monthly data as of 5/31/2016. Past performance is no guarantee of future results.

The U.S. Treasury market has benefited from the trend as well. Foreign buying of U.S. Treasuries surged by $136 billion, or 2.2% year over year, in the first quarter of 2016, according to the Federal Reserve’s flow of funds report, reversing a decline seen in 2015. So far in the second quarter, Treasury auctions have seen strong bidding from indirect bidders—usually foreign investors—for 10 and 30-year bonds. Even at a paltry 1.61% yield, U.S. Treasury bonds are attractive compared with Japanese bonds at –0.16% and German bonds at 0.02%. As long as yields are near or below zero in other markets, demand for U.S. Treasuries is likely to remain firm.

Treasury holdings

Source: Board of Governors of the Federal Reserve System. Z.1 Financial Accounts of the United States, Federal Reserve Statistical Release as of 6/9/ 2015 and Historical Annual Tables, 1990-2004.

3. Global growth has slowed

Because long-term bond yields are often a function of expectations for short-term rates combined with a risk premium for inflation, the steep drop implies reduced prospects for growth going forward. The current yields in major bond markets imply little expectation for central banks to raise rates or for inflation to rebound over the course of the next decade. Flattening yield curves—in which the difference between long-term rates and short-term rates is narrowing—are another sign of declining expectations for growth and inflation over the long run. Supporting this view, the World Bank recently lowered its estimates for global GDP growth this year to 2.4%, from the 2.9% pace projected in January. It cited “sluggish growth in advanced economies, stubbornly low commodity prices, weak global trade and diminishing capital flows” as the reasons behind the downgrade in expectations. Also, the Organisation for Economic Co-operation and Development (OECD)’s leading indicators suggest that growth momentum in several parts of the world is slowing. As long as growth prospects remain muted, bond yields are likely to remain low.

Global leading economic indicators show sluggish growth

Source: OECD, as of March 2016. The OECD’s work is based on continued monitoring of events in member countries as well as outside the OECD area, and includes regular projections of short- and medium-term economic developments.

Risk up/reward down

While we expect global bond yields to remain low or even fall further in the next few months, investors are facing a diminishing risk/reward outlook for their international bond investments. Investors may find themselves paying to hold foreign bonds rather than getting paid for it. Prices could continue to rise, but as yields move into negative territory, earning positive returns will require either yields falling further below zero, or foreign currencies rising relative to the dollar.

For investors with some allocation to foreign bonds, we suggest re-assessing that allocation. If the international bonds you hold in your portfolio or through a bond fund have appreciated sharply, it may be time to reallocate some of those profits into less-risky bonds. International bonds provide diversification in a portfolio, so some allocation makes sense, but if you find yourself holding negative-yielding bonds in your portfolio or through your bond fund, it may be time to reassess that exposure.

Important Disclosures

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