Should You Invest in Global Bonds with Record Low Yields?

Why Global Bonds May Be Overvalued

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Global bond yields have been near- or below-zero for the past several years as central banks have tried to stimulate the global economy. At the same time, there has been strong demand for bonds among investors due to the lofty valuations in other asset classes. These trends are likely to continue into the second half of the year, but the upside for international bond investors may be limited given the lack of room for upside appreciation.

In this article, we will take a look at why global bond yields have been depressed and why these dynamics may not continue indefinitely into the future.

Why Are Bond Yields So Low?

There are a number of different reasons that global bond yields have fallen across both developed and emerging market economies.

The most significant catalyst has been aggressive bond buying by central banks, which hold record amounts of government debt. In the U.S., the Federal Reserve holds more than $4 trillion worth of government bonds that represent nearly a quarter of the country’s gross domestic product (GDP). The Bank of Japan is the most significant buyer in the global market, holding government bonds worth more than 80% of the country’s GDP.

The second most significant catalyst has been investor demand for bonds amid the global economic uncertainty. Since pension funds and insurance companies are obligated to pay distributions, they have a high incentive to find high-yielding debt instruments.

The demand for yield has led both developed and emerging market bonds to move higher in price, and thereby, significantly reduced the yields paid on even riskier sovereign debts.

The final reason that bond yields are low is the perception that inflation will remain tame over the coming years. After all, bond yields reflect both short-term interest rates and inflation expectations.

The record low yields suggest that investors don’t see inflation rebounding over the coming years and, as a result, little expectation for central banks to take action to stem inflation by raising interest rates over time.

Are Bonds Still an Attractive Asset?

Record low – and occasionally negative – interest rates put the bond market in an interesting position that creates little upside for investors over the long run.

Investors purchasing bonds are vulnerable to both rising interest rates and defaults in the case of corporate bonds. When it comes to rising interest rates, the threat is amplified by the fact that the effective duration of bonds has reached all-time highs. Bonds with higher duration suffer greater losses when interest rates are on the rise, but many investors don’t seem too concerned with the prospects of higher interest rates for the time being.

Many countries have responded by selling longer term debt to secure record low rates. For instance, Spain issued 50-year bonds alongside France and Belgium while Italy is considering doing the same. Japan’s 30-year bonds were also sold to a willing audience despite being called the “most overpriced security on the face of the Earth” by a hedge fund executive.

These buys could be interpreted as signs of a bubble in the bond markets.

Finding Better Opportunities

International investors may want to consider diversifying into safer bonds in order avoid the impact of a rate hike or higher inflation in the future.

The best way to diversify is by purchasing international bond exchange-traded funds (ETFs) that hold a wide array of different bonds. Since some of these funds may be overweight in developed country bonds, it’s important to ensure diversification into emerging market bonds that may be less at-risk. Corporate bond ETFs may also be worth considering as an alternative to sovereign debts, although it’s important to account for the risk of default.

Some international bond ETFs to consider include:

  • iShares Interest Rate Hedged Corporate Bond ETF (LQDH)
  • Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (IGIH) • iShares Interest Rate Hedged High Yield Bond ETF (HYGH)
  • WisdomTree High Yield Bond Zero Duration Fund (HYZD)

The Bottom Line

Global bond yields have been near- or below-zero for several years, which has introduced some interesting dynamics to the market. While bond yields could move lower, the risk/reward ratio is stacked against investors as yields move further into negative territory, since there’s a cost to holding the bonds. International investors holding these negative yielding bonds may want to consider diversifying into less risky bonds or potentially other asset classes.