The yield on 10 year bonds in many developed countries has fallen sharply in recent months. This reflects markets’ expectation that interest rates will remain low for an extended period. Low rates are due to a number of factors including low forecasts for growth and inflation, investors’ desire for certain / fixed returns and central bank policies to help restart growth.
Unfortunately low returns are not good for savers or retirees as it provides them with little investment return without taking some investment risk. Real interest rates – that is rates after taking into account inflation – are actually negative in many countries. In New Zealand yields on 10 year government bonds are somewhat higher at 3.2%. However, after taking off tax and allowing for inflation the real yield on NZ Government Bonds is close to zero.
|Government Bond Yields 6 June 2012|
|5 year||10 year|
In the short-term investors continue to buy government bonds as a way to escape from market volatility and due to the forecast of very low world growth and inflation. As rates have fallen long maturity bonds have generated good capital gains as investors are prepared to pay a premium for existing bonds that have coupons (interest payments) above market rates. However, on a medium term basis we believe that the risk / return for many government bonds is poor. Whilst we believe that growth and interest rates are likely to remain low by taking some risk investors can generate a decent return premium over government bond yields. Another, issue is that there is a risk that stimulatory central bank policies may eventually lead to inflation which would see interest rates rise and some of the capital gains made on government bonds reverse.
The current investment environment with low rates, low growth and very high market volatility is challenging for investors. However, we believe that it offers opportunities, albeit investors need to take an element of risk and accept some short-term volatility to achieve returns. Additionally, managing this risk (through diversification and thorough investment research) will be vital to delivering consistent investment returns.