Although I spent all my university studies considering government bonds of developed countries as a risk-free asset, today I certainly cannot say the same thing. The incredible compression of interest rates that we have been witnessing for years makes bond investing increasingly risky in the face of ever smaller returns.
Therefore we have never been so far from the concept of zero risk (or risk-free), and I confess that in AdviseOnly we often wonder about the opportunity to keep this asset class in the portfolio (which in fact we use in moderation and only on specific segments) , which we can consider in "bubble". Still, there still seems to be some reason to hold government bonds.
In a previous post, we analyzed the factors underlying the variation in government bond yields and we realized that there is a factor that explains about 90% of the variability of the interest rate curve, which in our view coincides to a large extent with duration risk, i.e. parallel movements towards the interest rate curve.
So what could push interest rates up structurally and penalize the entire asset class? There are two major causes.
THE END OF THE MONETARY EXPANSION CYCLE (UNLIKELY)
As early as December 2014, we began to gradually reduce the bond exposure of our portfolios (in particular by shortening duration and maturities) by gradually and generally anticipating the increase in interest rates following the Fed's moves. But it didn't go like this: the Fed took longer than expected to raise rates and most other world banks increased monetary stimulus. Considering that inflation is under control and a good portion of the world economy is growing below its potential, the risk of seeing some central bank willing to “pull the handbrake” on the economy seems unlikely to us today.
Even the Fed, certainly the central bank closest to its mandate objectives, could stall, also because otherwise it would be rowing against the other central banks, and this would mean further strengthening the US dollar, which certainly wouldn't help US exports. That said, a further 25 basis point increase within the year would not change the overall view: we believe monetary policies will remain accommodative for quite some time to come.
AN AGGRESSIVE TAX POLICY (UNLIKELY)
One of the reasons that have pushed interest rates so low is that, globally, the demand for low-risk assets (government bonds) is greater than the supply (new issues). Although the thesis is gaining momentum within the economic community that there is a need for fiscal stimulus in countries that can afford it, there is no substantial fiscal stimulus plan on the horizon yet to increase the supply of outstanding bonds. Even Germany, which would have the resources and the need to increase public investment in infrastructure, seems destined to keep its accounts in an austerity regime. The fiscal position should improve somewhat everywhere. The 2016 stimulus is only temporary.
THE STATUS QUO
Although government bonds don't offer great yields, barring a new financial crisis (always possible, but not particularly likely), yields are bound to remain exceptionally low for a long time, and maybe in some cases they could fall further (not much, though ).
Up until now, portfolio diversification has worked and there are no reasons to believe that it won't do its job in the future too, so without taking particular risks on individual countries, maintain exposure to this asset class, especially in target portfolios. .
