Recent headlines have highlighted negative, fiscally-driven moves in most major government bond markets. Bond investors are adjusting to a new reality where debt sustainability will be a major concern going forward. To navigate the new regime and see through the noise, it is useful to break yields down into components with economically meaningful labels, and to distinguish between secular and short-term moves. Doing this forms the basis for understanding expected returns across bond markets.
Although the headlines around government bonds are negative, the outlook for bond investors can depend on their investment horizon. Long-term expected real returns are underpinned by persistently higher real rates, as indicated by the current levels of equilibrium real rates. Reading from market-based estimates of inflation trends, long-horizon inflation expectations are still well-anchored. These are the key drivers to watch for longer-term investors considering changes to their strategic asset allocation. Despite this, most of the commentary concentrates on day-to-day moves in yields which tend to wash out over time.
For expected returns, it is important to distinguish between secular shifts (equilibrium real rates and inflation trends) and transitory moves, captured mainly by term premiums. Equilibrium real rates, inflation trends, and monetary policy jointly make up the ‘carry’ component of expected returns while term premium variation drives the ‘value’ component. These temporary moves provide scope for tactical opportunities. AS Capital Market Assumptions include timely expected return estimates, produced daily, that add value for tactical positioning.
A natural question is whether term premiums can reprice to permanently higher levels. Historical episodes tell a different story: to the extent changes in how investors perceive the increases in the riskiness of government bonds are permanent, they tend to eventually show up as an increase in either equilibrium real rate or long-horizon inflation expectations. This follows from the reaction of central banks and fiscal authorities. This is a longer story we will write more about in the future, but a recent example is the UK gilt market in 2022, where the fiscally-driven sell-off initially showed up in a higher term premium that then morphed into an increase in r-star.
In the chart below, we show our latest estimates of term premiums for G10 markets and China. The estimates are positive with the exception of the UK gilts. Although yields on UK gilts are elevated, it shows up as higher equilibrium real rate, indicating that higher real yields are likely here to stay.
To assess how well our estimates of expected returns capture tactical opportunities, we look at whether our estimates of short-horizon expected returns line up with future realised returns. Both expected and realised returns refer to the country composite government bond indices. The chart below shows our estimates of expected returns at a one-year horizon, and subsequently realised returns on G10 government bonds over the period 2004 to 2025. We use non-overlapping annual periods, starting in May each year.
The relationship between expected and realised returns follows a 45-degree line, which indicates that our estimates are unbiased predictors of subsequently realised returns. This isn’t the case when only using yields as predictors, showing the value of carefully modelling yield curve components.
The scatterplot is a simple way of illustrating the value that AS CMAs can add for asset allocation and tactical macro strategies. If you are interested in learning more, please reach out to us.
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