While many fixed income investors seeking returns may see little point holding government bonds, PGIM fixed income head of global bonds Robert Tipp says think again.
The US-based investor responsible for US$900 billion in bonds told delegates at Investment Magazine’s Investors Symposium it was worth holding some government bonds in their allocations
Bonds most expensive in six years
His advice comes as Australian government bonds are priced at their most expensive in six years compared to fundamentals, based on the yield gap to swap rate.
Tipp says insurers and other fixed income investors should seek risk premiums across different asset classes and get paid for holding less-liquid assets, but bonds’ duration factor as a hedge was effective.
“On the government bond side though, private debt is 10-year and you are getting paid a spread over the cash rate,” he said.
“I, personally, and depending on liability durations, would probably still want to have some duration associated with that or some of that, I would go to the swap market in the government bond market.’’
“Looking at the S curve in Australia, rates are forecast to go up a couple of per cent, and the odds of that happening are low, I think you’re going to earn a risk premium from your derivatives rolling down the yield curve.”
Real trouble in the world
But in a low interest rate environment when there’s “real trouble in the world”, government bonds tend to provide a buffer, he said.
“High quality, fixed income, duration tends to provide a buffer. I think we’re having an economic expansion that’s fairly durable and that will be positive to spread products, but I think duration is going to be a positive hedge factor in this environment.”
The best approach for fixed income investors in a low, range-bound rate environment, is to stay with one strategic asset allocation, Tipp said.
“Investors have had a hard time doing that with equity values too high and, in bonds, rates are really low, but the secular fundamentals are all continuing in one way,’’ he said.
The impact of a decelerating economy in China, leads to a lower discount-rate world, while the US’s economic boost from reopening after Covid was already slowing out, he added.
“It will be volatile, and probably more volatile than we’re used to seeing so staying in strategic asset allocation (means) stocks will outperform bonds, high risk bonds will outperform low risk bonds and bonds will outperform cash.’’
Central banks got themselves in trouble by describing current higher inflation “transitory”, when it appears it is more long-lived, but is this inflation enough to spark rate hikes, Tipp asked.
“The answer is probably no,” he said, “but the central banks are being careful in clearing the decks in being able to raise rates if they see this as a systemic problem within the next 12 months.’’
The trouble with sitting on cash
He maintained a problem for investors with decades-long experience in bond markets is that they have become used to seeing high real rates with 100 per cent liquidity, getting paid a real return for sitting on cash.
“That was part and parcel of a disinflationary monetary policy. They (central banks) were running high real rates and dis-inflating the economy and pulling money out of other activities to put us in this position of having really low inflation,’’ Tipp said.
“So fast forward to where we are now, liquidity and no risk, you should have to pay for that.
“Personally, I think central banks should be running higher interest rates and encouraging the private sector. They’re trying to drive higher growth, higher inflation, that can end up running these zero rates with negative real (bond) yields and people have to pay for it.”
Central bank mistakes
He said there have been some central bank policy mistakes, including the RBA making an “aggressive commitment” to keep rates low until 2024, rather than providing condition-dependent guidance, but it was unlikely the cash rate would rise.
“If you get a real growth pulse that’s durable; inflation pulse that’s durable, it will result in higher rates, I think, if it’s not monetised,’’ Tipp said.
“Most countries look like their rates are backed up and going back to an environment that’s as hot as 2019 or hotter on a perpetual basis over the next few years and staying there. I think that’s unrealistically high.”