Back to basics for bonds
By Alexis Bienvenu, Fund Manager, La Financière de l’Echiquier (LFDE) | June 2024
A long-dormant source of yield is now flowing again. But it is clearly not springing from a new wave of growth. Indeed, there is reason to doubt that global momentum can gain in strength, as China’s expansion slows to a more normal pace and growth rates in debt-ridden rich countries converge on sluggish levels. But there is another source of wealth: bonds. Admittedly, at a time when France’s sovereign rating has been downgraded again by Standard & Poor’s, and when other benchmark countries such as Japan and the United States could suffer the same fate, investing in bonds, even high-quality ones, may seem unreasonable. And yet they are able to quench the thirst for yield, and are likely to do so for several years to come.
15 years after the 2008 crisis, nominal yields have regained their very long-term strength. Over 100 years, the US 10-year bond has offered an average return of 4.8%,[1] close to the current level. But this level includes the period of inflation in the 1970s and 80s, when yields occasionally exceeded 15%. Over the last 25 years, the average eases to 3.3%. From this point of view, the current return represents a premium of more than 1% to the average, and will accumulate over 10 years. That is a rare market opportunity. In the eurozone, the French 10-year bond, currently yielding over 3%, is above its 25-year average (2.7%).
Additionally, inflation-adjusted real long-term yields have returned to positive territory. Even if inflation were to remain structurally higher than it has been for the past 20 years, it is hard to see how it could sustainably remain above the current level of long-term yields. Central banks would act. The preservation of positive “real” yields therefore seems sustainable.
It is true that the quality of government bonds will come under intense scrutiny in the coming years. Structurally unbalanced budgets are unlikely to improve in the near future, with public spending set to increase, if only to finance transitions, particularly energy and demographic. At this stage, however, the likely downgrades in sovereign credit ratings are unlikely to result in significant financial losses: the credit ratings of rich countries remain high and are only slowly being downgraded. Moreover, rich countries are proving resourceful in meeting their financing needs. The case of Japan speaks volumes: despite a public debt-to-GDP ratio of over 250%, it has no problem accessing the market, helped in particular by its central bank. Finally, there are few low-risk investment alternatives for investors. Even if only by default, governments and robust companies are sure to attract some of the capital that cannot flow into equities, gold, luxury goods or cryptocurrencies. Indeed, some corporate bonds continue to be rated higher in the countries in which they are domiciled, such as Microsoft and Johnson & Johnson – which are rated AAA, the highest – even though S&P and Fitch have both downgraded the US sovereign rating.
As an added bonus, central banks appear poised to cut interest rates, which should ease the yield curve. In addition to the intrinsic return on bonds already issued, there could be a return linked to the appreciation of their price, offering the prospect of a double win.
A new era is dawning on the market, one in which investing in high-quality bonds could once again become a preferred option and a source of returns that investors can enjoy for a long time to come.