This month’s Editorial by Olivier de Berranger, Deputy Chief Executive Officer and CIO, and Alexis Bienvenu, Fund Manager, La Financière de l’Echiquier (LFDE).
A new era of abundance is upon us. Not, alas, in political, social, environmental or even economic terms. Rather, it is for bondholders. It takes us back a long way, to those long-forgotten days more than a decade ago when bonds paid money for little or no risk.
As in any quest, investors had to go through a lot to reach this paradise. They had to endure zero or even negative interest rates. In 2020, they had to agree to lend money to the Austrian government for 100 years to get a meagre 0.85%. They then had to get through 2022, when even the least risky issues, such as German 10-year bonds, fell by more than 20%. At the same time, inflation was raging, reaching an annualised rate of nearly 10%. That took the real capital loss on these quality bonds to more than 30%! And 2023 has compounded the losses.
But all these setbacks have brought us back to normal, one might say almost to a golden age: lending to Germany now yields nearly 3% a year over 10 years, and to the United States almost 5%. And you can get another 2% or so by lending to high-quality companies…
Of course, this new world – or return to the old one – is not as rosy as it seems. Short-dated government bonds, for example, are paying more than long-dated ones, an imbalance that will one day be reversed. Yield spreads between government and corporate debt are average, not high, leaving downside risk in the event of an economic crisis leading to defaults. And inflation is not yet fully under control, although we are getting there. It is still taking a few “real” percentage points off nominal yields. Finally, there are concerns about the sustainability of such high interest rates for companies and governments with stretched balance sheets. Hitherto protected by debt built up mainly when interest rates were low, the time is inevitably approaching when they will need to refinance their existing debt at higher rates. This could prove fatal for the most vulnerable borrowers… and their creditors.
But for creditors, the remedy lies at the very source of debtors’ woes: bond carry is now sufficient for any default on a well-diversified portfolio to quickly be offset by returns on other securities. And a further rise in yields affecting the price of already issued bonds would be offset within a reasonable time by the return of bond carry to significant levels. In any case, the situation will be much more favourable than it was a short while ago!
Of course, a good time for creditors is a distressing one for debtors, who have to do all they can to offset the new burden. They have to be more demanding or less generous with their customers, employees, shareholders or voters. There has already been a decline in share buybacks by US companies, which were previously boosting share prices.
But a world of over-prosperous creditors could bear the seeds of its own demise. The financial soundness of companies and governments alike could be threatened.
Fortunately, the threat is tolerable at this stage. The market is anticipating lower policy rates within the next few quarters. And central banks will be careful not to undermine the system. They will get up early, so that the new era in bonds is not wasted.
Our bond funds and buckets are already taking advantage of this new era, excited by the opportunities that are emerging after so many years of scarcity, and as demanding as ever in terms of issuer quality. After all, even when a tailwind is blowing, there will always be disappointments. In bonds as in equities, selectivity remains the order of the day.
