Risk of inflation makes long dated bonds in developed countries unattractive, according to fund managers

News - Funds

Written by Ray Clancy

Long dated bonds issued by developed countries are not appealing for investors because of the risk of inflation from the fiscal and monetary stimulus in place, it is claimed.

Boston based money manager GMO said yields paid on government bonds from most advanced economies are already at very low levels, offering a ‘limited upside with a potentially uncapped downside’.

Edward Chancellor, a member of GMO’s asset allocation teams says in a research note that; ‘Under only one condition, that the world follows Japan’s experience of prolonged deflation, do they offer any chance of a reasonable return’. ‘As investors, such asymmetric payoff profiles don't appeal to us,’ he added.

Allowing inflation to come back, Chancellor argued, is the easiest political alternative for debt burdened governments that need to redistribute wealth from creditors to borrowers.
Instead of focusing on the maintenance of price stability, policy makers have gone to extreme lengths to avoid deflation, he said.

‘The policy of quantitative easing, as practiced by the Federal Reserve and other central banks, is a monetary experiment fraught with danger,’ Chancellor said, noting that history records that all periods of high inflation have originated with debt monetization.

GMO’s view on inflation and the performance of sovereign bonds contrasts with the opinion of Jeffrey Gundlach, the former chief investment officer of TWC, and now chief executive of his own investment firm, DoubleLine, based in Los Angeles.

Gundlach has been advising his clients to buy long dated government bonds such as 10 year US Treasuries to benefit from deflationary pressures and flight to quality action.

For GMO, a return to inflation in the US and the UK is much more likely than a debt default, despite those countries’ large structural fiscal deficits and huge unfunded contingent liabilities.

Extrapolating those fiscal deficits indefinitely into the future and pointing to an inevitable default is a mistake, Chancellor says. ‘In time, welfare and pension obligations will be reduced and taxes will rise. We are already witnessing the first round of fiscal tightening in the UK and elsewhere,’ he explained.

Meanwhile, those countries have deep financial markets and domestic banking systems that are able to absorb vast amounts of government debt, like they did in the past, without a sovereign default, he argued.

The fact that, unlike Greece, both the US and the UK retain control over their monetary policies and currencies brings additional protection against default, since they can inflate or devalue their way out of the debt crisis, GMO said.

GMO is ringing the alarm bell for Japan, however. With its domestic savings rate in steep decline and limited capacity of both the Bank of Japan and commercial banks to absorb more debt, the country is stuck in a debt trap, Chancellor said.

‘Unless Japan changes direction, its public credit will come under threat,’ the fund manager added.