Since the financial crisis, investors have become accustomed to the idea that bonds could not be expected to provide a return and that bond returns were only delivered if interest rates continued to fall against expectations.
In fact, interest rates kept falling until mid-2020, when the German 10-year bond yield bottomed out at -0.9%. After that, bonds were something to avoid like the plague.
During the same period, inflation was extremely low – despite very loose monetary policy from the world’s central banks. As fiscal policy was also eased at full blast over the corona crisis and home equity was translated into large increases in online shopping, vacation homes and car purchases, we have now seen a surge in inflation.
Bond investors have sent interest rates soaring to reflect the risk that central banks are simply not in control of inflation. This is a huge shock because financial markets generally use the interest rate on safe government bonds to price other assets.
For example, the interest rate on mortgage bonds should be the same as government bonds with the same maturity – but with an additional yield added to reflect the fact that mortgage bonds are slightly more uncertain.
The same happens with corporate bonds, EM government bonds, real estate and equities. All of these riskier assets have had a miserable first half of the year because, for example, equity investors now actually have a real alternative in the form of bonds. At the time of writing, Totalkredit’s 30-year 4% mortgage bond is trading at 93, giving a yield to maturity of around 4.5%.
Now, the stock market can be expected to yield more in the long run, but it is also at a significantly higher risk (about 3 times greater fluctuations). For the first time in many years, the very expensive stock markets have a viable, liquid and relatively safe alternative.
Looking at the outlook for the economy, bonds actually look even more interesting. The price of lumber has collapsed in the US, indicating a large, expected decline in construction activity. The same will happen here at home, where margins for developers are under severe pressure.
In all likelihood, growth in the second and/or third quarter will be negative and employment will fall. The fact that central banks are only now starting to tighten monetary policy is also a problem. They are tightening on the way into a recession and making things worse. By all accounts, consumption and inflation will therefore peak in the very near future and interest rates should also be close to the peak.
Bonds have therefore become interesting again.