Long Bond Investors Forced Into Short-Term Box

The recent collapse in bond yields has changed the risk dynamics quite substantially. With many markets yielding negative or near-zero rates, this isn’t just a low interest-rate environment any longer. It is, potentially, a deeply irrational environment. GMO’s latest quarterly letter by Ben Inker has some good thoughts on long duration bonds that will sound familiar to regular readers:

The case for long-term government bonds today as an investment is a very thin one. The case for them as a speculation is perhaps better. After all, if there are price-insensitive buyers for a security who have already stated that they will be continuing to buy large amounts of it in the coming months, it may make sense to front run them by buying the asset ahead of time to sell to them. It is possible that this will be a good money maker in the coming months. Much of the time, markets price in events that are known (or thought to be known) ahead of time. But sometimes the market seems to be taken by surprise by events that have actually been well-telegraphed. Today’s all-time low bond yields may very well be eclipsed by tomorrow’s even lower ones.

But let me suggest another course of action for the speculator with a somewhat longer time horizon. While the telegraphed behavior of central banks over the coming year or two might easily drive these bond yields lower, the central banks have no intention of continuing their policies forever. Their goal is to generate sustainable inflation and economic growth, and when that has been achieved – whether through their policies or despite them – the buying will stop. This should leave the pricing of bonds in the hands of profit-minded investors. And both history and common sense suggest the yields such investors will demand will be a good deal higher.

Admittedly, it is a tough ask to an investment committee to replace their holdings in “safe” long-term government bonds with a short in those same bonds. But no one should be under the illusion that long-term bonds trading at these yields are truly safe investments. In all probability they are safe against a loss of value under deflation, but in just about any other circumstance their expected real returns are somewhere between approximately zero to strongly negative.

In our multi-asset portfolios our net duration today is approximately zero. While we do have some long positions in a few of the least unappealing government bond markets, those are matched by shorts in markets where we find long-term bond yields to be far too low. We are trying to resist the temptation to therefore load up more heavily on equities or corporate credit. Our concerns about equities should be well-known by now. As for corporate credit, while today’s spreads over Treasuries look okay, the liquidity in these markets has become shockingly poor, and we believe it is appropriate to demand an extra margin of safety when operating in markets where it has become very difficult to transact. This leaves us owning more conservative “alternative” strategies as a superior anchor to the portfolio in tough economic times compared to government bonds, whose yields make little sense.

We’re already seeing this play out in 2015. Long bonds are negative on the year and have fallen 8.5% from their highs. That’s a dramatic decline. I’ll summarize my own similar view:

1. There is an increasingly high risk that the lowflation trade is overly owned.
2. Long bonds are likely to generate low or no real returns going forward.
3. Long bonds as a generally safe asset are ADDING to the risk of permanent loss rather than protecting against it as it normally would.
4. An investor who wants to hold some bond allocation is being forced into shorter durations OR is likely to perform better by timing moves in long duration bonds.

The paltry future returns combined with low inflation expectations will force long-term bond investors to become increasingly short-term. The alternative of holding a 30 year for a 2-3% annualized return just doesn’t make a lot of sense from a risk adjusted basis. The whole Inker note on bonds is a good one.