Chris Joye who writes for the AFR and also manages a fixed interest fund, discusses the implications.
But first some background. Below is a chart of US government 10 year bond yields since 1900.
When bond yields fall, the value of existing bonds rise in value (because the discounted value of the future cash flow from those bonds, rises.) Therefore, since 1981, while bond yields have been falling, bonds have been delivering excellent returns - very high returns compared to long-term average returns. By contrast, when bond yields rise, substantial capital losses can be delivered by bonds.
Over the last few years, we saw US bond yields fall to the lowest level seen since 1900. A lot of people believe that the bond market (eg in US, UK and Australia) is in the "biggest bubble of them all". Eg
And now to the 13/1/2018 article by Chris Joye. Here are some key sections:
'Is the fixed-rate government bond market – to be distinguished from floating-rate securities – in the mother-of-all bubbles? Very likely. Has it burst? Maybe, although the evidence is not persuasive. As it normalises, will it cause mayhem in other sectors? Probably.'
'This dramatic lowering of the yield curve (notwithstanding trend economic growth and a skinny unemployment rate) is the key reason why the prices of shares, commercial property, residential property and private equity have all soared since the correction in 2008 and 2009. As governments forced discount rates down by buying their own bonds, the present value of everything automatically inflated.'
'Let's return to the question of the fixed-rate bond bubble.'
'This begs the question: how much higher could they (Australian bond yields) realistically go? The RBA has made it clear that it thinks its normal overnight cash rate should be around 3.5 per cent, or 2 percentage points above the prevailing rate. Remember we also need to add in a term premium for interest-rate risk on future yields.
So if we assume that five-year (10-year) risk-free rates ascend from 2.40 per cent (2.75 per cent) today to, say, 4 per cent (4.5 per cent), the value of a five-year (10-year) government bond will shrink by about 8 per cent (17 per cent). That's telling us that a supposedly risk-free, AAA rated Aussie government bond will lose 17 per cent of its value if the 10-year yield simply returns to around its mid-2013 level. ...... Now extrapolate that mark-to-market (negative) impact on the risk-free benchmark to risky assets like property and shares. One can imagine potentially larger (negative) valuation changes, which could be quite shocking for folks who regard these investments as a one-way bet. '
Bruce Baker comment: "Bond proxies" (investments that have a seemingly-reliable income yield - such as some shares, listed property, infrastructure, commercial property) have, in effect, a longer duration than 10 year government bonds, and therefore should expect to have a larger loss as bond yields rise than 10-year government bonds in the context of the discussion by Chris Joye above.
On bond yields, in his 13/January/2018 weekly newsletter, Jon Pain makes the following comments:
"And it further leads me to believe that we are witnessing one of the greatest financial market mispricings that I have ever seen. Yes, I am talking about government bond yields and we all know which is the most important of them all."
"I firmly believe, if you hadn’t already guessed, that we are at a major inflexion point in terms of the global inflationary cycle."
"Rising inflation is the key macro risk for 2018."
"I have such a high degree of conviction about my inflation view it is terrifying. The second and third derivatives of this change are more complex."
For another perspective on bond proxies, here are some views from the very successful fund manager, Jacob Mitchell of Antipodes Partners: http://www.afr.com/markets/antipodes-jacob-mitchell-buckles-down-for-chinese-share-rush-20180114-h0iaa7
'That means the so-called bond proxies, or stocks that have soared in value because investors perceive their income to be reliable, and therefore bond-like. In a world of ultra-low rates those stocks have been bid up dramatically. But as the Fed eyes more rate hikes, Japan slows its bond purchases and China threatens to slow its US bond purchases, 2018 may finally be the year the bond bull market breaks. Mitchell says shorting the bond proxies presents an "attractive, asymmetric risk/reward" trade. That's because they could come under pressure even if the broader stock market continues to melt up, as bond rates are likely to respond to the improved growth outlook by heading higher.