Investment consultancy Towers Watson has warned against holding government bonds and inflation-linked bonds with about a ten-year maturity and downgraded these assets to “highly unattractive”.
The firm said increased investor appetite for safe assets, as well as quantitative easing – where central banks buy government bonds to inflate the money supply – has increased demand and driven down yields. This means owners of ten-year bonds are not being compensated for the risks they take when holding the bonds.
A major hazard is duration risk, which is the possibility that interest rates will rise and cause bond values to fall. Duration risk is greater when bond yields are low.
Robert Brown, chairman of Towers Watson’s global investment committee, said government and inflation-linked bonds with a maturity of about ten years “offer a very low risk premium over cash and/or are discounting a high probability of a macroeconomic backdrop of ten to fifteen years of economic stagnation”.
“This is too pessimistic in our view and our forecast returns suggest bonds are now unattractive,” he said.
The consultancy warned that deleveraging, the continuance of easy monetary policy and ongoing demand for safe assets is likely to keep bond yields low. However, in the medium term there is likely to be a faster cyclical recovery than most ten-year bond markets are pricing, which implies that these bonds are expensive, said the firm.
Brown said the implications for asset allocation depends on investors' benchmarks. If an investor has a diversified portfolio and a cash benchmark, they should reduce duration risk by, for example, selling government bonds with a ten-year duration and buying cash and high-quality corporate bonds instead.
But for pension funds that invest against bond-like liabilities, it makes sense to build a “controlled short interest rate position” and increase hedging. To replace risk in the portfolio, Brown recommends high-quality corporate credit, on which Towers Watson has maintained its “moderately attractive” view.
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