How bonds became stocks and stocks became bonds

Accurate systematic bond pricing becomes the key in solving volatility in bond prices due to stock-like trading

Source: Financial Times

Bonds have become the new equities, say fund managers, stirring concerns that dangers are lurking in the supposedly safest corners of financial markets.

Historically, investors have for the most part bought government bonds for their security and interest payments, while they have sought out equities in the hope of capitalising on rising prices. There are exceptions, of course, but by and large this relationship has remained constant through the modern era.

Now, though, investors are forced to live with the opposite — bonds that yield nothing but that gain in price, and equities that are relied on for their streams of dividends rather than their rising prices.

It is a flip that has unsettled many analysts and money managers. “It’s terrible,” said Con Michalakis, chief investment officer of Statewide Super, an Australian pension fund which manages A$9.7bn ($6.6bn) in assets.

“Everyone has become a short-term trader, not buying bonds to hold them. That’s not a good thing,” he said. “And I don’t think people understand the volatility of equities.”

Negative-yielding bonds are at the heart of the problem. Prices are so high that investors are certain to get back less than they paid, via interest and principal, if they hold the bond to maturity. Yet investor demand — coupled with central bank buying — has expanded the universe of sub-zero yielding debt to $13.3tn.

Although there are several regulatory and technical reasons why investors would buy bonds with negative yields, some are doing so in the expectation that they can later sell them on at an even higher price.

Low-yielding bonds are also producing outsized price gains that dwarf their modest coupon payments. The Bloomberg Barclays Global Aggregate bond index has returned over 6 per cent this year and about 8 per cent over the past 12 months, despite yielding just 1.37 per cent. Even with modest gains from here, this year’s performance could mark the second time the index has surpassed 7 per cent since the financial crisis.

With the European Central Bank set to restart its quantitative easing programme, the Federal Reserve cutting interest rates and the Bank of Japan continuing to pump money into the global monetary system, it is hard to see an end to the broad market rally.

“Some bond buyers are motivated by hopes of capital gains,” said Jeffrey Gundlach, chief executive of DoubleLine Capital, which has $147bn in assets.

In some cases, yield-starved investors try to make up the shortfall by buying increasingly risky debt, Mr Gundlach noted. But others are seeking out stocks that pay healthy dividends instead. Leaving aside ultra-long dated 30-year Treasuries, the entire US government bond market now yields less than the average S&P 500 stock (2.1 per cent).

“Institutions and individuals need income, but income from bonds and other traditional sources has been diminished,” said Kera Van Valen, a portfolio manager at Epoch Investment Partners, which manages $33bn in assets. “Dividends are always positive contributors to equity market returns and companies that pay consistent and growing dividends have historically provided downside protection in volatile equity market environments.”

French bank Société Générale has also advised its clients to seek out steady dividend payers in response to rock-bottom global bond yields. That includes an S&P index of dividend “aristocrats”, which have reliably increased cash payouts over the past 25 years. But the advice comes with a warning: a deep recession would see a sharp sell-off in such stocks.

Meantime, this shift in portfolio construction represents a long-established market orthodoxy being turned on its head.

Through the 19th century and the first half of the 20th, the US stock market’s dividend yield was higher than the average bond yield, simply because investors assumed that riskier assets like equities should pay them more than relatively safe and steady fixed income.

But what had seemed an immutable law began to change in the late 1950s, when the 10-year Treasury yield vaulted over the S&P 500 dividend yield.