Bond traders have been making out like bandits since the global financial crisis. A portfolio of Australian government bonds with maturities longer than 10 years has delivered annual total returns of over 12 per cent since December 2007.
Yet the preconditions for the mother-of-all bond market reckonings are sliding into place.
This contingency, which AMP’s Shane Oliver believes is a “significant risk”, could result in wiping more than $60 billion off Aussie bond values, with steep capital losses.
To properly understand these risks, one needs to appreciate how extraordinary current circumstances are. When doing so, it helps to keep in mind a key principle: bonds that pay fixed, as opposed to variable, rates have prices that are inversely related to external interest rates.
If you invested in a bond paying an annual fixed coupon of, say, 3 per cent, and market interest rates surge to 5 per cent, that bond would be worth substantially less than when you bought it. The converse is also true: if market rates decline below the bond’s fixed coupon, it would be worth more.
This is why Australian government bond prices have soared since 2007: market yields have fallen sharply as global central banks have floored policy rates close to zero and printed unprecedented amounts of money to fund public and private debt.
According to the Reserve Bank of Australia, the total value of long-term Australian debt securities has leapt 500 per cent from $150 billion in 1993 to $890 billion today. Long-term government debt has jumped 300 per cent from $108 billion in October 2003 to $440 billion today. So there is more debt outstanding than ever before.
Yet government bond yields are near record lows. RBA data shows that in December 2012 the yield on 10-year government bonds was only 3.23 per cent despite our historically low jobless rate and trend-like growth. Since 1993 the average 10-year government bond yield has been nearly double this at 6.12 per cent. Even if one only examines the past decade of data, the average yield has been much higher, at 5.29 per cent.
Oliver says “the long-term equilibrium yield for 10-year Aussie government bonds should be around 5.25 to 5.50 per cent, which is way above current levels.
“This assumes inflation of 2.5 per cent plus real economic growth of 2.75 to 3 per cent. The idea is that risk-free borrowing costs should be in line with the economy’s nominal growth.”
The concern is that if long-term yields start normalising because of a better-than-expected global recovery after healthy growth in the two largest economies, China and the US, investors in fixed-rate bonds could suffer massive mark-to-market losses.
And there is a precedent: the last great bond market crash in 1994.
Australia is 48 months into an expansionary cycle since the zero per cent (six-monthly) GDP trough touched in December 2008. Inflation is allegedly benign, and bond yields are near record lows.
Fortune magazine describes the “Great Bond Market Massacre” in eerily similar terms: “In January 1994, the 34th month of economic expansion, bond yields were historically low and inflation seemed negligible. Wages were going nowhere, and companies dared not raise prices. But within seven short months of that promising start . . . 1994 became the worst bond market loss in history.
“With long-term rates rising in every major country, the worldwide decline in bond values [was about] $1.5 trillion.” This inflicted “heavy damage on financial companies, hedge funds, and bond mutual funds”.
Investors like to think Australia’s AAA-rated government bonds are bullet-proof. While the Commonwealth is unlikely to default on its debts, this does not mean the market price of its bonds cannot collapse. Between January and October 1994 the value of long-term Australian government bonds slumped a stunning 17.8 per cent .
To better understand what might happen in 2013,the Weekend Financial Review asked two fixed-income experts with contrasting views, UBS and FIIG, to analyse the likelihood of alternative scenarios.
UBS chief economist Scott Haslem says, “we are at the moderately more hawkish end of the spectrum, looking for an on-hold RBA, and a gradual re-acceleration of global activity led by a stronger-than-consensus US economy with no hard landing in China”.
Haslem says this will result in yields grinding higher in 2013. “But with the growth pick-up likely to be gradual, deleveraging persisting, inflation contained, and monetary policies staying easy”, yields are likely to climb only 50 to 100 basis points, which is “not the 200 basis points experienced in the mid-1990s”.
FIIG’s Stephen Nash says yields are more likely to fall than rise this year, which will provide a fillip for bond prices. He forecasts a “modest decline in yields of around 50 basis points, as growth in the US moves close to flat, and Europe continues to disappoint with the prospect of zero growth in 2013 and 2014 increasing”.
Nash thinks that after monitoring the effects of its 175 basis points’ worth of rate cuts, the RBA will ease its cash rate further to 2.50 per cent in the second half of 2013 as the transition from mining-led growth proves problematic.
Based on FIIG and UBS analysis, a 100-basis point increase in yields will see bond prices fall by roughly 3.8 per cent, which will knock $26 billion off the value of the $683 billion fixed-rate bond universe .
A harsher scenario where yields jump 200 basis points, as they did in 1994, or return to their decade average, could result in $60 billion in losses with bond prices dropping more than 8 per cent.
What could trigger this bond market crash?
“It is far easier to imagine the factors that would deliver a sharper-than-expected fall in prices than we already forecast for 2013,” says Haslem.
“Top of the list is a stronger-than-predicted US economy that could see bond investors revisit their assumptions about Fed policy, pushing long-term yields up.
“A recent UBS survey of global clients showed that investors saw the biggest long-term risk as inflation, and the biggest mis-pricing being US Treasury bonds.”
What about the alternative of yields falling, which would boost bonds?
Haslem says this might arise from “a negative shock to the US consumer from failed negotiations in February around the US debt ceiling that leads to significant cuts in public spending in tandem with renewed problems in Europe, potentially centred in Spain.”
But he cautions that “downside outcomes in Europe and to a lesser extent the US remain well priced [and] they would hardly constitute a surprise”.
Nash canvasses slow Chinese growth of 5.5 per cent causing disappointing global outcomes. He also thinks war between Israel and Iran is a possibility, which could push growth-sapping oil prices higher. Combined with an Aussie dollar punching through US110¢, this might force the RBA’s cash rate down to 2 per cent, which is where ANZ predicts it will end up.
While bond prices would appreciate 4 per cent, share prices would decline by double digits, as they did in 2011.
Oliver agrees with Haslem’s base-case of escalating yields driving capital losses. He notes that current bond yields reflect tail risks that will likely fade.
Indeed, Oliver believes there is “a significant chance safe-haven demand for bonds [will] evaporate”.
The Australian Financial Review