July 12, 2011
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Since peaking in 1981, yields on the government bonds of most developed nations have fallen almost continuously, as illustrated in the following graph.
This decline is due, in large measure, to the success of central bankers in reigning in inflation from the heated double-digit numbers of three decades ago. Also, oil prices fell precipitously in the 1980s while deregulation and globalization fuelled competition and exerted downward pressure on prices.
Recent research has highlighted other causes. A McKinsey Global Institute study1 found that a dramatic fall-off in the level of global investment in physical assets such as infrastructure, plant and equipment since 1980 reduced the demand for capital relative to previous decades and hence, depressed interest rates. Some economists including Fed Chairman Bernanke2 have suggested that a worldwide shortage of safe assets, particularly in the emerging markets, reduced Treasury yields over the past decade. According to this view, this shortage has been exacerbated by the recent financial crisis.
Although many investors are aware of the challenge lower bond yields present to achieving adequate long-term portfolio returns, a focus on nominal yields (which include both a real and an expected inflation component3) conceals the scope of the problem. For investors, it is real (i.e., net of inflation) bond yields that matter. The inflationary component of bond yields only offsets expected price increases. As illustrated in the following graph, real government bond yields on both short-term (in dark) and long-term (in light) Treasury Inflation Protected Securities (TIPS), the principal value of which increases with inflation, have also fallen precipitously.
1. McKinsey Global Institute, Farewell to cheap capital? The implications of long-term shifts in global investment and saving, December, 2010.
2. Bernanke, Ben S., Carol Bertaut, Laurie DeMarco, Steven Kamin, “International Capital Flows and the returns to safe assets in the United States 2003- 2007”, Banque de France Financial Stability Review, No. 15, February 2011.
3. The yield of bond actually incorporates four elements: 1) a real return component for deferring consumption and assuming the risk of investment; b) an expected inflation premium; 3) an inflation uncertainty premium for the risk of changing inflation rates; and 4) a term premium for the risk of extending the investment horizon. For brevity sake, we have simplified this into a real return and an expected inflation component. We have also ignored any liquidity premium.
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