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What if bond prices take a dive?

There are a lot of reasons why investors could, or perhaps should, be worried we’re headed for a bond market correction. Chief Economist Dr Shane Oliver shares his predictions for bonds and the implications for investors across other asset classes.



There are a lot of reasons why investors could, or perhaps should, be worried we’re headed for a bond market crash, or even a mini bond-market correction, a-la 1994.

I’ll outline the reasons why it’s easy to imagine a perfect storm brewing which could lead to an abrupt sell off in the global bond market in the near term.

But first, I’m going to cut to the chase and point out that I think a dramatic crash in bond prices is most likely going to be avoided. The main reason I say this is because high debt levels mean interest rate rises are more potent than they may otherwise have been, meaning it’s unlikely Central Banks will need to raise interest rates quickly to curb rising inflation. Add to that, Central Banks in Europe, Japan, and Australia remain a fair way off tightening rates, so global monetary policy will remain easy for a while yet. And ongoing technological innovation should constrain how far inflation will go up when it does.

With that said, I do believe we are witnessing the end of the 35-40 year super cycle in which bond yields have been constantly falling. 

We think bond yields are on the way up again – probably quicker than a lot of people think, when you consider the market has only priced in two US Federal Reserve rate rises this year. We think there will be four or possibly five Fed rate hikes in 2018.

Bond prices will fall and the fall in bond prices globally – led of course by the United States – will have implications for the value of investments in other asset classes.

So here are all the valid reasons why we’re at the end of the super cycle bull market for bonds and we can expect bond prices to fall from here.

Inflation is coming back in the US and there are signs the return to inflation is coming on the heels of this synchronised global growth we’ve been hearing about.

The Head of the Dynamic Markets Fund, Nader Naeimi, outlined the reasons we’re seeing the return of inflation in this recent commentary.

The return of inflation and global growth is occurring at a time when bond yields remain well below levels consistent with likely long-term nominal growth. Over the long-term, nominal bond yields tend to average around long-term nominal GDP growth.   


 
Furthermore, bonds remain over loved with a huge post-Global Financial Crisis (GFC) inflow into bond funds in the US, which leaves bond prices vulnerable to a reversal if investor sentiment towards them turns negative. 



Not only that, demand for US bonds is dropping as central banks’ buying of bonds is starting to slow.

There are of course real implications for investors as bond prices begin to fall and yields start rising.

Most obviously, investors can expect mediocre returns from sovereign bonds. Over the medium term, the return an investor will get from a bond will basically be driven by what the yield was when they invested.

Higher bond yields will also impact share market returns as they make shares more expensive. Shares will be okay if the rise in bond yields is gradual and so can be offset by rising earnings – as we expect this year – but a large abrupt back up in bond yields will be more of a concern. In any case, expect a more volatile ride in shares.

Defensive high-yield sectors of the share market are likely to remain under pressure as bond yields rise. This includes real estate investment trusts and utilities that benefitted from falling bond yields. With bond yields trending up, REITs and utilities are likely to remain relative underperformers.

Because there’s unlikely to be an aggressive rise in bond yields for the reasons stated earlier, when it comes to real assets like unlisted commercial property and unlisted infrastructure, the search for yield is likely to remain a return driver.

Commercial property has lagged listed property in responding to the decline in bond yields and so the gap between commercial property yields and bond yields leaves commercial property still looking attractive. Heading into the GFC, it was only when bond yields rose above commercial property yields that commercial property prices started to struggle. We are a long way from that but as bond yields trend higher, the valuation boost to commercial property and infrastructure returns will gradually fade.

Naturally, as falling inflation gives way to rising inflation, and bond yields head higher, many assume the worst, such as a rerun of the 1994 mini bond crash or some sort of “perfect storm” where inflation takes off, but central banks are powerless to stop it. 
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