Time-Adjusted Risk-Reward Balance — Are We About to See a Long Overdue Correction to Bond Markets?
Over the past decade we have witnessed an unprecedented period of “time-adjusted risk-return imbalance”. By this I mean that bond investors have not been adequately rewarded for the level of risk they assume on both the credit profile and the maturity term of bonds.
The starting point for any decision to invest in bonds (fixed-interest debt securities) is the underlying government bond curve. This is the series of different maturity periods that a government issues debt to, and a curve plots these dates and interest yields. The instruments are commonly referred to as US Treasury bonds or New Zealand Government bonds. The interest-rate yield of such a curve is often referred to as the “risk-free rate” and reflects that country’s underlying interest rate to which all other bonds issued in that country’s currency are usually referenced. Risk-free implies that government bonds are the safest investment instrument and fully protect investors’ capital and yields in the domestic country of issue, on the basis that the bonds are held to maturity.
Usually, we would expect to see a normal government bond “risk-free” yield curve to be upward sloping to reflect the basic premise that the longer the time duration the higher the risk factor and accordingly, one needs a higher return to compensate. This is true of government risk as much as it is true for corporate risk, ie., in the same way that investors learnt that not all AAA rated bonds were created equally in the 2007–8 GFC, not all countries’ “risk-free” government bonds are considered equal. Using a roading analogy, US Treasury bonds are considered the global “risk-free” bond super-motorway and by comparison, New Zealand Government bonds a state highway and as such, New Zealand Government bonds nearly always have a premium (spread) interest-rate yield over and above comparative US Treasury bonds. The following 50-year chart tracks the US 10-year treasury bond yields against Fed Funds short-term interest rates and clearly illustrates that the longer-term 10-year rate is usually higher than the shorter-term Fed Fund rate, signalling an upward sloping (positive) yield curve.
Global government bond “risk-free” yield curves have been flat and even downward sloping over recent years reflecting the collective race by central banks to get to zero % interest rates (and in many cases negative interest rates) to stimulate economic growth and to awaken a decade or two of non-existent inflation.
Bond (fixed-income) investment decisions are usually based on the large, safe, and liquid government bond “risk-free” yield curve motorways and the biggest super motorway globally is the US Treasury bond market. The rest of the world usually follows the US Treasury bond market and the old financial market saying, “when the US catches a cold, we all get the flu” is very close to the mark. Plainly put, when US Treasury bond interest rates rise, so too do ours.
The above chart illustrates that New Zealand’s government risk-free bond yields are higher than the US risk-free bond yields with 10-year New Zealand Government bonds yielding 73.9 basis points more (0.74%) at nearly 4.0%.
Once bond investors have chosen their bond motorway, they usually use a credit rating to determine their bond-risk appetite in terms of time adjusted risk-return. I.e., if the investor is happy to accept higher risk to achieve a higher interest-rate yield, a credit rating acts like an AA vehicle check to determine how safe your bond (car) is for any off-motorway investment excursions. The longer the investment period the greater the chance that you might crash your investment car on a dodgy road or that your car breaks down. That’s the theory.
Credit ratings provided by global independent rating agencies such as S&P Global Ratings, Moody’s and Fitch essentially assess the probability of default and capacity to repay financial obligations on fixed-income assets such as bonds.
The above probabilities for each rating grade incrementally increase over time and require a steeper time-adjusted risk-reward yield curve compared to the underlying government bond risk-free yield curve. The lower one goes down the rating scale and the longer the investment period, the steeper the curve.
A BBB bond with a 5-year default probability of 1.42% has twice as much risk of default when one considers a 10-year term at 3.23%, therefore a re-balanced time-adjusted risk-reward yield should be approximately twice the spread to the underlying government bond risk-free yield, i.e. if a 5-year BBB bond is properly priced at 1.50% above 5-year the US treasury bond yield, then a 10-year BBB should be pricing at 3.00% above the US 10-year Treasury bond risk-free yield).
Why the imbalance?
The previous decade of super-low interest rates, inflated asset values, and a tsunami of cash looking for investment homes has seen a classic supply and demand imbalance where too much money has chased too few bonds, not helped by central bankers mopping up a considerable supply of bonds during their quantitative easing (QE) foodfest. The ECB purchased 10-year BBB bonds at extremely tight spreads to the respective government bond yield, and the global investment community accordingly chased any bond that could yield a return above inflation, even if it was barely investment grade (BBB). We can now observe a serious distortion/disconnect to global bonds time-adjusted risk-reward balance. Quite simply, long-dated bond yield curves are not steep enough and the relative pricing differential between AA, A and BBB is not reflecting realistic time-adjusted risk-reward bond yields.
This can be observed in New Zealand’s bond market by the following comparison of 5-year bond investments as of 1 September 2022.
Note the complete lack of pricing differentiation between AA, A and BBB bonds.
The global rise in interest rates currently underway, actioned by central bankers in a belated effort to fight global inflation, will negatively impact business and household credit profiles. The higher that rates rise and the longer that interest rates are elevated (extended restrictive monetary policy conditions), the greater the probability of loan/bond arrears and defaults. As more and more defaults occur, the re-balancing of bond time-adjusted risk-returns will likely occur. This means that long-term funding will get more expensive, the result of a likely double whammy of higher and steeper US and other government bond risk-free rate yield curves and a re-balancing of credit risk reflected in higher corporate bond spreads. The following chart tracks the closely lagging relationship between US bankruptcies and rising short-term interest rates.
Higher for longer interest rates is the likely medicine to be dished out by the US Fed in its mandated fight against inflation and this will spill over to New Zealand and be reflected in our interest rate actions. Business and household wallets will be under cashflow pressure from both higher interest rates and high inflation causing more debt-servicing arrears and defaults. This will likely set the rating agencies off on a credit rating down-grading spree and cause bond investors to look more closely at the credit profile of their bond portfolio and ensure they are being properly rewarded for the time-adjusted risk.
If the saying “all roads lead to Rome” applies to the US Treasury bond super motorway, it is reasonable to assume that what happens to the US bond market will be matched and or indeed expanded in other global markets such as New Zealand.
The following chart shows a hypothetical forecast of what the US Treasury bond yield curve and BBB yield curve (dotted lines) could look like as of 31 March 2023 assuming higher for longer US Fed application of restrictive monetary policy (based on Jerome Powell’s 26 August 2022 speech at the Jackson Hole symposium), the diminished demand for bonds from belt tightening central banks and an increase in business/ household arrears/ defaults.
It is not too much of a stretch to see US interest rates rise to between 4 and 5% for the Fed to “finish the job” on containing and indeed lowering inflation to their 1–3% limits. We are unlikely to be too different here in New Zealand and will probably match their rises in interest rates. This could see New Zealand Government bond rates rise to between 4.50% and 5.50% and BBB pricing rise to between 6 and 7% across our own 10-year bond yield curves.
This strengthens my view that the time is not quite right to re-enter the bond market and that it might be wise to limit bond maturities to terms shorter than 3 years for the next few months.
Director SRH Consulting
Financial Markets Risk Adviser