Insight & Analysis

Government bond holders shaken and stirred (into action)

Published: Jun 2021

Treasurers have lost faith in government bonds as real returns dwindle, leading to increased interest in corporate and index-linked bonds from treasury teams searching for positive returns – or at least trying to avoid losing money.

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The sell-off of US government bonds during the early months of 2021 may have slowed, but US government IOUs continue to be relatively unattractive.

US Department of the Treasury data shows that more than US$400bn of these bonds were sold in the first three months of the year, while asset management firm Schroders notes that the yield or return on US ten-year Treasury bonds declined from 1.74% to 1.63% last month.

The rule of thumb is that low interest rates encourage economic growth and therefore rising inflation, whereas higher interest rates lead to slower economic growth and a slowdown in inflation.

Economic growth is clearly a good thing for businesses and government bonds are undoubtedly the safest of safe investments, but when corporates buy them they still want to get a return.

In April, the US consumer price index was up 0.8% and has risen by 4.2% over the last 12 months. So with ten-year US treasuries (government bonds) currently yielding around 1.6% per annum, for example, any business holding them is losing money once inflation is taken into account.

It is widely accepted that inflation is likely to rise in 2021 although there is less consensus on how far or how fast rates will increase in each country. The UK consumer prices index was up by 1.6% for the 12 months to April compared with 1% from March 2020-March 2021, whereas ten-year UK government bonds – known as gilts – are returning only around 0.9%.

The prospect of the gap between inflation and the yield on government bonds rising even further over the coming months has encouraged treasurers to look at alternatives such as corporate bonds and index-linked bonds.

Investment grade bonds – otherwise known as high grade bonds – are company IOUs with high ratings from credit rating agencies such as Moody’s, S&P; and Fitch. An example of an investment grade corporate bond is the General Electric Capital Corp bond, which is currently offering an annual yield of just under 6%.

According to data from the Securities Industry and Financial Markets Association, US$548bn of investment grade debt was issued in the US in the first four months of 2021.

One of the obvious places to look for corporate bond opportunities at the moment is among companies in sectors that will benefit from the reopening of the global economy as lockdown measures are eased.

Corporate bonds offer a higher yield than government bonds to reflect the risk of a company defaulting on the interest payments. Even Amazon had to offer an average yield around 0.3% higher than ten-year US treasury bonds when it sold US$18.5bn of new bonds earlier this month – and no one expects Amazon to go bust any time soon.

Jason Hollands, Managing Director, Tilney Investment Management refers to index-linked bonds (where the level of interest paid on the principal is linked to a price index such as the consumer price index) as another asset class that that can help protect against inflation. “If you believe higher inflation is coming you want to be underweight government bonds,” he says.

“Corporates should move away from government bonds, particularly those issued by core European countries such as Germany or France,” agrees Agnès Belaisch, Chief European Strategist at Barings.

Kathy Jones, Chief Fixed Income Strategist at the Schwab Center for Financial Research recommends investing in bonds with a variety of durations or maturities (the point at which the principal has to be repaid) from as little as three years to as many as 12.

The one note of caution is that treasurers need to consider how easy it would be to sell corporate bonds if they required access to the cash tied up in them. The market for government bonds is much more liquid, meaning trading volumes are higher and buyers are more readily available.

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