What the Past Tells Us About the Future of Fixed-Income Returns

For clues as to how European, U.K. and U.S. government bond yields may perform, take a look at Japanese government bonds.


As low bond yields cast a long shadow over fixed-income markets, investors are struggling to balance risk and return in the face of soaring bond prices.

It may be instructive to scour Japan’s experience for clues to the fate of today’s extraordinarily low rate environment — and if Japan’s road map is any guide, U.S., U.K. and German yields likely will fall even further than they already have.

What does all of this mean for global fixed-income investors? As they pick their way through an investment universe bloated by increased debt issuance, the advantages of an actively managed approach have been thrown into stark relief.

Conventional wisdom assumes that what goes down must come up. But will it really?

In the absence of the bond investor’s two enemies, growth and inflation, we expect government bond yields to remain low. In Europe markets have defied expectations that already extremely low government bond yields could not go lower by breaking through the zero rate barrier. As the European Central Bank’s quantitative easing program buys more debt than countries are issuing, the resulting negative net supply pipeline has led to an environment in which nearly 40 percent of euro zone government bonds trade with a negative yield.

As a result of the pervasiveness of negative-yielding government bonds in Europe, Treasuries actually look attractive on a relative basis, and this is likely to keep a cap on U.S. government bond rates as fixed-income investors search for yield.


Additionally, there is historical evidence that the ten-year Treasury yield will remain anchored based on its relationship with the fed funds rate. Typically, when a terminal rate is reached at the end of a Federal Reserve tightening cycle, the yield curve is inverted — that is, the ten-year Treasury yield is lower than the base rate. Given the challenges we expect the Fed to have in reaching a terminal rate of 2 percent in the current tightening cycle, we believe that the ten-year Treasury will not go much higher than its current level.

So if government bond yields in the U.S. and Europe aren’t going up, can they continue to fall? We can look to Japan for clues.

In an attempt to encourage lending and revive demand after an asset price bubble burst, Japan’s central bank slashed interest rates from 6 percent in 1991 to less than 1 percent in 1995 and eventually to zero in 1999. With some short-lived exceptions, Japanese government bond (JGB) yields have remained at ultralow levels ever since.

Much of the Japanese scenario seems akin to the current situation in the U.S., U.K. and Europe, with the authorities struggling to ignite economic growth against a backdrop of high aggregate debt levels.

Although we often think of quantitative easing as a recent phenomenon, the Bank of Japan pioneered this concept in 2001, when it initiated current-account-balance targeting as a way to increase liquidity in the financial system. Low government bond yields are often assumed to have a negative impact on fixed-income returns given the assumption that the next move in rates will be up and the lack of yield will reduce the ability to generate return and cushion against rate rises. Nevertheless, Japanese fixed income has continued to provide investors with decent returns: The Bloomberg Japan Sovereign Bond Index provided annualized returns of 2.25 percent over the five years through 2015.

Looking back five years, ten-year JGBs yielded an annualized 0.88 percent; as of the end of 2015, the yield was just 0.27 percent. The Bank of Japan’s move in January to cut deposit rates into negative territory suggests that government bond yields could move even lower. Although in absolute terms a return of barely 2 percent may not strike investors as impressive, these returns are ahead of inflation and powerfully demonstrate the ability of government bonds to deliver returns in a low-yield environment.

If Japan is the guide to the future, then we can conclude that U.S., U.K. and German yields are likely to fall further from here and remain extraordinarily low.

With today’s low-yield environment has come massive growth in global fixed-income markets, providing investors with an expanded universe offering the potential for greater diversification, enhanced yield and a more flexible duration profile. The bigger world of debt issuance brings both opportunities and risks, highlighting the importance of an actively managed investment approach.

Traditional fixed-income benchmark-based investing is clearly no longer fit for purpose. Portfolios once positioned in line with market-cap-weighted indexes can no longer provide sufficient protection against rising rates. Issuers extending the duration of their debt in a low-yield environment will result in an eroded yield cushion, serving to concentrate rather than diversify risk in bond benchmarks. That makes it all the more imperative to invest only in those countries and companies in which investors have strong conviction that they will be repaid, with interest.

Nick Gartside is the international chief investment officer of fixed income at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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