As inflation picks up and central banks start hiking interest rates, the "super cycle" bull market in bonds has run its course – but fears of a bond crash are overdone, says AMP Capital.
In a note published last week, AMP Capital chief economist Shane Oliver noted that inflation – which has been falling since the mid-1970s – is back on the rise, with deflation risks giving way to inflation risks.
“Since late 2016, our assessment has been that the super cycle bull market in bonds is over,” Mr Oliver wrote.
“Naturally, as falling inflation gives way to rising inflation and bond yields head higher, many assume the worst – such as a rerun of the 1994 mini bond crash or some sort of ‘perfect storm’.”
But while bond yields looked to rise, this perfect storm is “unlikely” to eventuate, he said.
“Historically, bond yields have remained low after a long-term downswing for around several years as it takes a while for growth and inflation expectations to really turn back up,” Mr Oliver said.
The rates would hike gradually, and central banks in Europe, Asia and Australia would not be tightening monetary policy very soon.
“Finally, the idea that high debt levels mean that central banks will either have to live with a debt crisis or much higher inflation is nonsense,” Mr Oliver said.
“In fact, high debt levels mean central banks have more power than in the past to control inflation.”
Mr Oliver also pointed to certain implications that rising bond yields would have on investors.
“Firstly, expect mediocre returns from sovereign bonds,” he said.
Rising bond yields meant investor returns will “basically be driven by what the yield was when they invested” in the medium term – and capital losses in the short-term.
“Secondly, higher bond yields will impact share market returns as they make shares more expensive,” Mr Oliver said.
“Shares will be OK if the rise in bond yields is gradual and so can be offset by rising earnings – as we expect this year – but a large abrupt back up in bond yields will be more of a concern.”
Investors should therefore expect more volatility in shares this year, he warned.
“Defensive high-yield sectors of the share market”, such as real estate investment trust and utilities,also seem likely to remain under pressure.
With the rise of bond yields, the REIT and utilities sector look to be “relative underperformers”, Mr Oliver said.
“When it comes to real assets like unlisted commercial property and unlisted infrastructure, the search for yield is likely to remain a return driver unless bond yields rise aggressively,” he said.