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OPINION

Bonds' real trouble

Bonds' real trouble
July 7, 2015
Bonds' real trouble

So, why have they done so?

In truth, there's nothing unusual about real and nominal yields moving in the same direction. If we look at three-month changes in 10-year yields since May 1997 (when the Bank of England was made operationally independent) the correlation between conventional and index-linked gilts has been a hefty 0.5. And it has been even larger when yields move a lot. Since May 1997 there have been 16 three-month periods in which nominal yields rose by 0.5 percentage points or more; real yields rose on 15 of these occasions.

In this sense, it is perfectly normal for index-linked yields to rise when conventional ones do.

One common reason for this is that both yields are driven by changes in investors' risk appetite. When this increases, investors sell safer assets, so both index-linked and conventional yields rise.

This, however, cannot explain the recent rise in yields: share prices have fallen in the last three months, which suggests that risk appetite has declined.

Instead, I suspect that what's happened is that tail risk has diminished. A few weeks ago, investors feared that there was a small chance that deflation would become entrenched and that this would harm economies by raising real interest rates and real debt burdens. They bought both real and nominal bonds as insurance against this small but nasty risk. As this risk has declined, however, demand for both types of bond has fallen, so yields have risen.

If this is the case, then the recent sell-off might not be the start of a long-term rise in yields. What's changed is not so much the central mass of the probability distribution of future scenarios but merely the far tail of that distribution. The fundamental facts of a shortage of safe assets, savings glut and risk of secular stagnation haven't much changed - and all of them justify low yields.

There's another implication of this: it raises a doubt about the merits of government bond funds.

It's not just real and nominal yields that tend to move together. So too do bonds of different maturities; for example, since May 1997 there has been a correlation of 0.7 between three-month changes in two and 10-year yields. This implies that there are few diversification opportunities within the gilt market, so you can't much spread bond risk by holding a basket of them. Instead, you need other assets - such as cash.

This doesn't mean bond funds are useless: there are some investors for whom they do serve a purpose. Instead, it means that - for many of us - bonds are safe only if they are held directly and to maturity. The safe asset for you is one that matures on the date that you need the cash. Anything else is risky.