Bond Yields: Where's The Floor?

The globe is awash in debt, deficits are exploding and the Euro is about to collapse…right? Well then why in the heck are six countries out of the G-7 seeing their 10-year sovereign debt trade at 2.5% or lower on a consistent downward long-term trajectory? What’s more, three of the six countries witnessing their rates plummet are from Europe, despite pundits continually calling for the demise of the euro zone.

Here is a snapshot of 10-year sovereign debt yields for the majority of the G-7 countries over the last few decades:

Source: TradingEconomics.com

The sole G-7 member missing from the bond yield charts above? Italy. Although Italy’s deficits are not massive (Italy actually has a smaller deficit than U.S. as a percentage of GDP -- 3.9% in 2011), its Debt/GDP ratio has been large and rising (see chart below).

Source: TradingEconomics.com

As the globe plodded through the financial crisis of 2008-2009, investors flocked to the perceived stability of these larger developed countries’ bonds, even if they are merely better homes in a bad neighborhood right now. PIMCO likes to call these popular sovereign bonds, “cleaner, dirty shirts.” Buying sovereign debt from these less dirty-shirt countries, without sensitivity to price or yield, has been a lucrative trade that has worked consistently for quite some time. Now, however, with sovereign bond yields rapidly approaching 0%, it becomes mathematically impossible to fall lower than the bottom-rate floor that developed countries are standing on.

Bond bears have been wrong about the timing of the inevitable bond-price reversal, myself included, but the bulls are skating on thinner-and-thinner ice as rates continue moving lower. The bears may prolong their bragging rights if interest rates continue downward, or persist at these lower levels for extended periods of time. Eventually the “buy-the-dips” mentality dies, as we so poignantly experienced in 2000 when the technology dips turned into outright collapse.

The Flie's In The Bond-Binging Ointment
As long as equities remain in a trading range, the “risk-off” bond binging arguments will continue holding water. If corporate earnings remain elevated and stock buybacks carry on, the pain of deflating real returns will eventually become too unbearable for investors. As the insidious rising prices of energy, healthcare, food, leisure and general costs keep eating away everyone’s purchasing power, even the skeptics will become more impatient with the paltry returns they are earning. Earning negative real returns in Treasuries, CDs, money market accounts and other conservative investments is not going to help millions of Americans meet their future financial goals. Due to the laundry list of global economic concerns, large swaths of investors are still running and hiding, but this is not a sustainable strategy long term. The danger from these so-called “safe,” low-yielding asset classes is actually riskier than the perceived risk, in my view.

More Older Buyers
That said, I’ve consistently held there is a subset of investors, including a significant number of my Sidoxia Capital Management clients, that is in the later stage of retirement and have a rational need for capital preservation and income-generating assets (albeit low yielding). For this investor segment, portfolio construction is not executed due to an opportunistic urge of chasing potential outsized rates of return, but more-so out of necessity. Shorter time horizons eliminate the prudence of additional equity exposure because of the extra associated volatility. Unfortunately, many of the 76 million Baby Boomers will statistically live another 20 – 30 years based on actuarial life expectations, so the risks of being too conservative can dramatically outweigh the risks of increasing equity exposure. This is all stated in the context of stocks paying a higher yield than long-term Treasuries – the first time in a generation.

Short-term risks and uncertainties remain high, with Greek election outcomes unknown; a U.S. Presidential election in flux and an impending domestic fiscal cliff that needs to be addressed. But with interest rates accelerating toward 0% and investors’ fright-filled buying of pricey, low-yielding asset classes, many of these risks are already factored into current valuations. As it turns out, the pain of panic can be more detrimental than being stuck in over-priced assets, driven by rates dancing near an absolute floor.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.