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Bonds: Lower returns expected from global bonds

BNZ Investment Strategist Michael Daly says that global bonds will produce a lower return in 2001 than last year.

Friday, February 2nd 2001, 1:17PM

by Michael Daly

Long dated government bond yields had a cyclical peak exactly a year ago. Yields on 10 year bonds reached 6.7 % in the United States and around 5.7 % in the Euro area, while in Japan yields were at 1.8%. As at mid-January 2001, yields have dropped sharply to 5.2%, 4.9% and 1.5% respectively.

As a result the return for 2000 on government bonds, boosted by capital appreciation, was a strong 7.7% as measured by the Salomon World Government Bond Index.

Global bond funds offered in New Zealand tend as a rule to be fully hedged back into NZ dollars, and on this basis the return was an even more impressive 10.3%.

Bank of New Zealand Investment Management's view is that bond market participants are overly recognising recession and deflation risks in the way they are pricing bonds at present. This is seen in the fact that yields were last at these levels in early 1999, not long after the record lows reached when fears for the world's capital markets and deflationary pressures were at their maximum.

This is not to deny that rising concerns about the credit worthiness of borrowers are unfounded.

Globally, credit markets have shown signs of drying up and banks have tightened lending standards to companies as worries over debt servicing ability mount. Credit spreads between "junk" bonds and risk-free US Treasury bonds are at the highest levels since the 1991 recession. However, loan delinquency rates experienced by US banks are currently nowhere near what they were in 1991, and banks' balance sheets are in far better shape.

In Europe, the credit cycle is still rising - no sign of a buyers' strike except in the troubled, but narrow, telecommunications sector. On the basis of the evidence to hand it is hard to conclude that a US or global credit crunch is imminent this time around.

Late last year bond markets were charging ahead on the view that the US Federal Reserve would need to lower interest rates aggressively in 2001. The amount of easing reflected in the US Treasury yield curve has been the most since the deep recession of 1981, when nominal interest rates were at their highest in living memory. This seems overdone, in our view.

Bond markets' consensus forecast of inflation can be gauged from the difference in yield between nominal bonds and the yield on inflation linked bonds for the same maturity. This is known as the "breakeven" inflation rate. Above this rate, nominal bonds will underperform inflation-linked bonds.

The next five to seven years' inflation implicitly discounted in US intermediate term bonds is around 1.5% per annum. This is less than half the current US inflation rate, and seems an unrealistic assessment of medium inflation trends, given US inflation history.

Over the next couple of quarters, the expected monetary easing by the world's central banks will start to be discounted in terms of a healthier global economic environment in 2002. After what will probably be only a modest year for growth in 2001, next year's growth is likely to rebound above long run potential growth - in turn requiring a reversal of easy central bank policy. Bond markets will take their cue long before this better growth environment is visible in the data, and yields will begin to rise cyclically.

The one "maverick" could remain the Japanese bond market, which has marched to its own deflationary beat for the past few years. While it has seemed at times that the Japanese economy can only improve, given the strong performance of its trading partners in the last couple of years, and that price levels must at least stop falling, neither has happened yet.

The deflationary undertow seems entrenched for the time being, and even the ever rising fiscal deficit and government debt trend cannot seem to drive Japanese yields higher.

All in all, we expect a significantly lower return from world bonds this year

Michael Daly is the investment strategist at BNZ Investment Management.

Michael Daly is the investment strategist at BNZ Investment Management.

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