By Christopher Whittall and Tommy Stubbington
Bond investors are going long. The question is whether they will
regret it.
The European Central Bank's colossal dose of monetary stimulus
has crushed the returns available on bonds, encouraging investors
to buy longer-term debt that offers higher rewards.
But that strategy comes with a risk: The longer the life of a
bond, the higher its sensitivity to changes in interest rates. For
debt that isn't due for decades, even a small rise in interest rate
expectations can dramatically erode its value.
"Never in history have fixed income allocations been so risky,"
said Franck Dixmier, chief investment officer for European fixed
income at Allianz Global Investors, which oversees EUR1.8 trillion
($1.96 trillion) in assets.
"Even a small rise in yields" could lead to heavy losses in
investors' portfolios, he added. Bond yields rise when prices
fall.
The ECB began buying government bonds between two and 30 years
in length on March 9, in a program known as quantitative easing, or
QE, that will take its monthly asset purchases to EUR60 billion.
The market reaction has been most pronounced in longer-dated
bonds.
The yield on 30-year German government bonds has plummeted from
2.49% a year ago to 0.61%. Investors buying these long-dated bonds
only receive an extra 0.85 percentage point of yield over buying
two-year bonds, compared with around 2.28 percentage points a year
ago.
Piling into longer-dated bonds increases the duration of a bond
portfolio. A bond's duration measures when investors get paid. If a
bond matures many years in the future and pays little interest in
the meantime, the duration is high. And high duration makes the
value of a bond sensitive to changes in interest rates.
For instance, the duration of the 30-year German government bond
is currently 22, according to FactSet, compared with 20 a year ago.
This means that a one percentage point rise in interest rates will
slash around 22% off the price of that bond. By way of comparison,
the duration of the 10-year German bond, which pays nearly no
interest in its 10-year life, is just under 10.
High demand among investors for high-yielding bonds has
encouraged countries to lock in record low borrowing costs for
increasingly longer periods. As a result, over the past year, the
average duration of the iBoxx Eurozone sovereign bond index has
risen from 6.3 years to 7.34 years, its highest point since the
euro was launched, according to Markit.
Investors are facing a conundrum. If inflation rebounds, which
is the stated aim of the ECB's program, then long-term yields
should rise. Meanwhile, though, the ECB's buying is forcing funds
into riskier investments to earn decent returns.
"If QE works, investors could take substantial losses with the
30-year yield so low," said Philipp de Cassan, head of core euro
rates trading at Nomura. "All traders need to know is when the ECB
will stop buying: That is what's driving prices," he added.
Some analysts believe this could come to a head sooner rather
than later. Justin Knight, a rates strategist at UBS, argues that
the market has become fixated on ECB buying while ignoring the
increasingly compelling reasons to sell bonds, such as a rise in
investors' expected levels of inflation in the future.
Investors will also be tempted to sell given that euro area bond
yields have fallen so far that they offer the least attractive
returns of any government bonds across the globe after taking
currency effects into account.
"At some point soon we expect investors to sell bonds and yields
to rise, " said Mr. Knight.
Some investors aren't so sure, seeing any caution on buying
bonds as an ill-fated fight against a powerful ECB program. Nick
Gartside, head of fixed income at J.P. Morgan Asset Management,
notes that the scarcity of German bonds should continue to drag
yields down.
"[Duration] is a risk," he said. "But what would cause that [to
materialize]? The ECB stops buying bonds. That seems unlikely right
now."
Even so, some analysts and traders signal the sharp fall in bond
yields could be overdone. Andrew Millward, European head of rates
trading at Morgan Stanley, said that current yield levels look
"stretched" as they imply that Europe's economic troubles will last
for "decades".
"No one really believes that 30-year Germany bonds at 0.6% are a
good investment," added Zoeb Sachee, head of European government
bond trading at Citigroup.
Write to Christopher Whittall at christopher.whittall@wsj.com
and Tommy Stubbington at tommy.stubbington@wsj.com
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