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Text on screen: Jerry Tsai, Vice President, Quantitative Research Analyst
Tsai: Even though low yield is new for many countries, including the U.S., it is not a completely new phenomenon for some other developed economies. So what we can do here is that we can actually take a look at some of these other countries and see how their bonds have performed in these low yield environments and learn from their experiences.
So the most familiar case here is probably Japan. Yield in Japan has been low for over two decades. More specifically, for example, if you look at ten-year Japanese government bond yield, it has been below 2% since the late 1990s and fell below 1% in 2010.
Chevron split screen – Text on screen (left): Despite low yields, 10-year Japanese government bonds returned nearly 2.2% annually from 1999-2020; Image on right: Japan, Japanese Stock Exchange
And however, despite this low yield, during the period between 1999 and 2020,10-year JGB actually delivered a positive return, around 2.2% per year.
So some might think this is quite impressive given that the average 10-year bond yield during this period is only around 1%. So in addition, the return has also been quite consistent, and it was only negative for three out of the past 22 years.
Overall, 10-year JGB has delivered a Sharpe ratio of around 0.9. In comparison, during the same period, Japanese equities has a Sharpe ratio only around 0.3.
Why is this the case? How are the returns on bonds higher than their initial yields?
FULL PAGE GRAPHIC – Title: Roll down: How bond returns can be higher than their yields; text: Yields remain low + upward sloping yield curve + buying longer dated bonds with higher yields = positive returns by “rolling down the yield curve” (selling at a premium before maturity)
The secret here lies in rolldown. It is true that lower yields and rising rates could lead to lower bond returns.
However, the reality is that as long as yields remain low and the yield curve is in its normal upward-sloping shape, investors can actually collect a positive return by buying longer dated bonds with higher yields and let them roll down the yield curve.
So let’s consider an example here. Let’s consider the case where the yield curve is upward-sloping, and let’s assume that it doesn’t move across time. So in this case, think of an investor that buys a 10-year bond and holds it for one year.
So in this case, the investor will get a return that is higher than the initial 10-year bond yield. And why is that? That is because in addition to the 10-year bond yield, the 10-year bond is going to become a 9-year bond during this one year, and in the process, the yield is going to decrease. Therefore, it’s rewarding the investor for additional rolldown return.
Now, going back to the Japan example, in this case, the carry plus rolldown for the 10-year JGB over the last 22 years is on average around 1.9% per year, which contributes to the majority of the return in this case. And Japan is not alone here. Although bonds in Europe have been trading at a lower yield for a much shorter period of time, it nonetheless provides us with another example.
So here we’re going to take a look in Germany. In Germany, the 10-year German bund yield has fell below 1% in 2014 and the average 10-year yields in the last six years or so was around 20 basis points.
Chevron Split Screen – Text on left: Despite low yields, 10-year German government bonds returned nearly 3.6% over the past six years; Image on right: Japan, Japanese Stock Exchange
However, similar to Japan, despite the yield being so low, 10-year German bund has delivered a positive return, and it’s on average around 3.6% per year for the last six years.
So while the conditions for each of these cases are unique and different, these two case studies could provide some leading indicators for where the rest of us may be headed.
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Japanese Government Bond (JGB)
The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation of the portfolio returns.
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