Today, investors can lend to the US government for a guaranteed 2.3% real return. They will earn 2.3% plus inflation, whatever that might be, every year, for the full term, if held to maturity. This becomes a challenging hurdle for every other risk asset in portfolios to measure up against. A certain return in an uncertain world – a valid long-term case for owning inflation-linked bonds.
But that is the worst-case scenario. A short-term, cyclical rationale extends to both inflation-linked and conventional bonds. And it is arguably a more compelling case altogether.
Our base case is the economy and markets are too leveraged and too financialised to cope with 5% nominal rates and real rates over 2% for an extended period.
In this scenario, the global economy enters a recession or market crisis in which some combination of rate cuts and a flight to safe havens pushes bond yields down, lifting the capital values mechanically. A 2% fall in interest rates could generate a total return of more than 20% for 10 year bonds. Investors can sell these bonds and rotate into bombed out risk assets – thus setting up their expected returns for the next period.
A less well known, and even less well understood feature of bonds, is convexity. Convexity in practice means that from current yields, the price benefit from rates falling is significantly greater than the pain from rates rising. Heads you win, tails you don’t lose as much.
Lastly, from a portfolio perspective, how long can equities continue to ignore rising rates?
The rise in yields may have sown the seeds of its own destruction – the long and variable lags of monetary policy are still taking effect. Signs are increasingly visible that high interest rates are causing damage in financial markets (struggling small caps and banks, private equity and venture capital drying up) and now also in the real economy (higher corporate delinquencies, falling job openings and sky high mortgage rates). Any path involving yet higher bond yields most likely involves pain for markets in areas we have protection.