NOVEMBER 2010                                                                   Download PDF Version

New Normal or Back to Normal?

Many commentators are concerned that bond markets are entering a bubble. We share this concern but our primary questions remain:

  1. Are low rates necessarily unusual?

  2. Where are they likely to go from here?

  3. How do low rates affect the perception of asset classes other than bonds?

  4. What does this mean for investors?

For those that rely on bond investments for income, it has been a shock to realise that the purchasing power of their wealth has been severely diminished. The investment environment remains unusually uncertain, but perhaps the greatest danger lies in how investors react to the current situation.

The graph above clearly illustrates the cause for concern. It shows the evolution of 10 Year US government bond yields over the last 60 years with the grey bars showing periods of recession; clearly bonds have been excellent investments over the last thirty years. Yields could still be driven a little lower – Japanese 10 year rates have fluctuated between 1% and 2% since the late 1990s - but they are obviously bounded by 0% on the downside.

So, there are only two possible scenarios for the future:

  1. Bonds will either remain expensive as rates remain low, and therefore provide meagre returns to investors from here on (this is a mathematical fact not a forecast); or

  2. Bonds will fall in price as interest rates rise.

The latter will occur if and when economic activity and expectations for inflation pick up. Given this situation, investors must understand how much their bonds could be affected in the latter scenario. As a general rule the longer the maturity of the bond the more sensitive its price will be to changes in interest rates, therefore investors and their advisors should be analysing their fixed income portfolios in order to properly quantify the risks they are taking.

So, how unusual would it be for rates to remain low for a long period?

The long-run graph of the US 10 year treasury since 1798 shows two things; not only are current bond yields indeed unusual, but also that yields can stay low for a substantial period of time. The time of low rates at the end of the 19th century was the period of the industrial revolution, the time from the 1930s to the 1950s encompassed the Great Depression and the Second World War; both periods had followed strong rallies in the bond market. 

The recent recession, that officially ended in the USA in June 2009, was the deepest and longest recession since the Second World War. Normally one would expect a deep recession to be followed by a strong period of expansion in which rates would recover rapidly, but this recession was different in nature. For most of post war history many governments actually had to restrain their economies from growing too fast and generating inflation. The traditional role of the central bank was to ‘take away the punch bowl just as the party was getting going’.

However, another glance at the first chart will show that we enjoyed longer periods of prosperity and shorter recessions between 1982 and 2007. This stability lead to the growth of massive debts and investment in non-productive assets such as housing. This bubble has now burst and we are just left with the debts. Instead of raring to go again, many households and governments are more anxious about reducing their debts and are therefore saving more and spending less. This de-leveraging is a new factor in post war history and the subsequent lack of demand in the West is, at best, leading to a long and slow recovery and, at worst, could lead to the feared ‘double dip’.

One possible bright spot is the strength of corporate balance sheets (see the graph below), high levels of earnings and high cash balances being accumulated by the multi-national corporates. This is already leading to increased Merger and Acquisition activity and there is the hope that corporate spending in the US will help to counteract the factors outlined above.

So does this mean that we are indeed heading for a prolonged period of low interest rates and low yields; is this in fact a return to normal?

The danger is real but there are important differences between the two historical periods highlighted on the long-run graph above and our situation today. Economic growth was held back in both these times by adherence to the gold standard, which restricted growth of the money supply and therefore the main monetary tool that governments had was the increasing and decreasing of interest rates. Today, monetary authorities can employ quantitative easing (QE) and print as much money as they like; they believe that this will help stimulate economic activity. If successful, this would eventually boost rates - and inflation. However, Fed chief Ben Bernanke has admitted that the Fed does not have much experience of using this type of non traditional monetary policy; this is indeed a unique and worrying experiment.

In theory quantitative easing should work. The Fed ‘prints money’ to buy bonds in the market place, the proceeds of which then flow into bank balance sheets and becomes available for lending to multiple clients. However, it is impossible to force individuals to spend or invest just by making more money available in the system. Banks and individuals may simply react by hoarding money in cash balances or assets like gold (which may be happening at the moment). We may, therefore be heading towards the infamous ‘liquidity trap’.

Over the past two months, expectations of a second round of Quantitative Easing (QEII) have weakened the dollar and driven up the prices of bonds as well as virtually all risky assets. This is rather perverse because it is the fear of stuttering growth that has driven the Fed to considering a second round of QE. The most optimistic interpretation of this development is that the Fed will be successful in maintaining growth and will boost inflation, which will be bad for bonds, but in the meantime the extra demand for bonds will continue to drive prices up for a while longer. In other words bonds will drop eventually but not quite yet.

Either way, prudent investors must recognise that bonds are overvalued and start gauging their exposure to interest rate risk. It is very clear from the second graph that the last thirty years have been the exception rather than the norm over the past 200 years and are not a good guide to the future. Bill Gross of Pimco, one of the largest bond managers in the world, has recently called the end of the bond rally and acknowledged that he now sees himself as a ‘bear market manager’.

It is difficult to exaggerate the importance of this point because interest rates are used, in one way or another, to value all other assets. Everyone knows that cash should be put to work or it will lose value due to inflation and in relation to investments that are earning interest. However, when inflation and rates are low, cash will hold its value for longer; holding cash in the current environment is a perfectly valid investment strategy.

So what are the implications for investors? Bonds have traditionally been used as a source of income and to reduce the overall volatility of portfolios that also invest in stocks and other risky assets designed for long-term growth. The return of capital is also guaranteed at maturity – subject to credit risks – and bond holders are senior to stockholders in the event of bankruptcy. However:

  1. Bond investors must now take greater and greater risks with their capital to maintain the income they have traditionally enjoyed.

  2. Even if bond investors accept the reduction of income they will be subject to asymmetric price risks; i.e. there is a higher probability of prices falling rather than rising.

  3. There is the danger of bond investors inadvertently eating into their capital. This will happen when a bond has traded above its $100 par value. It maintains its coupon, but its yield to maturity will be much lower. Currently, while bonds are still being bid up this may not be a problem, but this should be carefully monitored.


  1. For a bond investor to maintain income greater risk will need to be taken;

  2. High yielding international blue-chip companies remain at relatively ‘cheap’ valuations and should be acquired;

  3. Given the uncertainty over the macro-economic environment and expected continued volatility in markets investors should be prepared to rebalance portfolios regularly, locking in smaller profits more frequently;

  4. In general most asset classes look over-priced at worst and fairly priced at best, therefore relative value is often the most one can seek;

  5. Holding cash remains a valid strategic investment allocation and allows an investor to retain greater optionality;

  6. Continued low interest rates could lead to new ‘bubbles’ appearing elsewhere either through a hoarding mentality (i.e. gold) or through short-term momentum (i.e. Asia). Investors should maintain a value discipline in their core portfolios to avoid running significant price risks from which it may be very difficult to recover. However, consciously speculative short term bets with small amounts of money may be a way of improving returns and avoiding the frustration of missing out on rallies that can go on for significant periods of time and further than logic would dictate;

  7. Certain long-term themes (i.e. the Asian consumer) remain valid and should be averaged into; and

  8. Hedge funds and macro funds remain a valid asset class, although exposure through a fund-of-funds may be the preferred route even bearing in mind the higher fees.

Please do not hesitate to contact Christopher Andrew:

Christopher Andrew                       
Tel: +44 20 7060 1400                    




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