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Opportunity (cost) knocks

US ten year Treasuries have delivered a zero real return to investors over the last five years, while the US equity market has increased by 87%.

This should not be a surprise. It makes sense for investors to pay up for lower volatility (even if this relationship does not always hold). US ten year Treasuries have certainly been less volatile than equities.

It is worth noting (as Tony discussed in January) that longer duration bonds had actually become more volatile than the S&P 500, even before the much discussed decline in equity volatility set in.

The issue will be whether the cold reality of the opportunity cost that has had to be paid to avoid short-term volatility will change investor perceptions. For much of the period since 2012 many investors have made it clear that they value return of capital more than return on capital. However human beings have a habit of forgetting what they used to believe. Will the risk that investors are worried about, shift from uncomfortable short term drawdowns to missing out on longer term returns? When these types of emotional forces take hold, it can tell you more about whether we are in a bubble than a valuation metric.

Whatever it took

Of course, the five year starting point of the charts above is not insignificant. Five years ago next Wednesday, Mario Draghi delivered his “whatever it takes” speech which affirmed the commitment of the ECB to preserve the Euro and support the financial system. It meant strong returns for assets in the European periphery that had been in the eye of the storm.

Italian investors who braved the Euro crisis have had a great five years.

Spanish investors have done even better.

Italian and Spanish investors have not faced the opportunity cost of hiding from volatility. However, this is because back in 2012, Italian and Spanish government bonds were no less volatile than the equity market.

Nor is it clear that this is a direct consequence of central bank policy, at least not in the way that it is often portrayed. Acting to support liquidity in the banking system, and helping change investor perceptions of peripheral bonds from that of credit risk to a sovereign risk, is vitally important, as are changes in market interest rate expectations.

However, the narrative that QE-driven flows into these assets have driven prices is less clear. Figures 3 and 4 above show that Italian and Spanish bond returns have actually been broadly flat since the start of 2015 – the point at which the ECB’s expanded asset purchase programme began (US purchases were halted in October 2014).

Last week a speech by ECB Executive Board Member Benoît Cœuré also presented evidence that the cash institutions receive from ECB bond purchases had tended to find their way into government bonds elsewhere in the world, most notably the US (which as we have seen has not resulted in strong returns from the Treasury market).

Rather, it seems that the starting point of yield has a part to play. Italian and Spanish ten-year bonds yielded 1.6% and 1.5% respectively in January 2015, and their real returns have been accordingly low since then. We can see that German Bunds, which had far lower yields five years ago, have not kept pace with the periphery.

As our colleagues at Bond Vigilantes have discussed, there are clearer signs of a QE impact in the corporate bond market, but when it comes to government bonds the above suggests that we should not lose sight of yields, irrespective of our forecasts of investor or central bank capital flows.

And with yields where they stand today, it seems that opportunity costs could well come knocking in Europe, just as they have in the US.