The returns on UK government bonds has fallen to a record low as investors move to safer assets over concerns about the global economy and the impact of the UK leaving the EU. The yields on UK 10 year gilts have dropped to 0.86% while the yields on German 10 year Bunds are now -0.13% and Japanese 10 year bonds -0.25%. This means that investors are paying the German government to hold their money. More than US$10tr of global sovereign debt is yielding less than zero.
The low yields on government bonds paints a pretty pessimistic picture of the global economy and suggests we are still set for an extended period of low inflation, something central bankers are trying their best to counter.
Investors buy bonds for the predictable and secure income stream they offer. Even so, yields have been falling for months. This time last year UK 10 year gilt yields were 2%.
With concerns over equity volatility investors will seek safe havens so gilt yields could fall further. Europe currently has ultra-low interest rates as well as the ECB pumping €80bn per month into the European bond markets. Both are driving yields down and correspondingly prices up.
Yields on US bonds are in global terms relatively attractive. The June US bond auction reported record demand from investment funds and foreign central banks. As far as government bonds are concerned US and UK bonds still pay modest yields.
With yields on government bonds so low, investors with a need for income are increasing their risk by moving to higher yielding noninvestment grade bonds. For this reason, high yield bonds have done well. With inflation expectations in the USA improving US inflation linked treasuries have also risen.
The positive economic sentiment that began in February has continued with generally positive returns from corporate bonds. Further weakening of the US$ and improvements in the commodity markets has assisted US high yield bonds. US high yield bonds are at the riskier end of the market but are amongst the best performing major asset this year with an average return of 7%.
However, default rates on high yield bonds have hit 3.9% due to deteriorating credit quality. Noninvestment grade rated American companies have debt equal to 48% of their assets. Fortunately, QE and low interest rates have spared the most highly indebted firms.
It is against this background we have set out our portfolio recommendations.