The unconventional monetary policies followed by several central banks since 2008 has led to an increase in the demand for bonds, thus increasing the price of bonds and pushing bond yields much lower than historical average yields. For example, in February 2015 10-year bond yield were 2% in the US, 1.6% in Spain, 0.4% in Germany and Japan and -0.04% in Switzerland.

These low and especially negative bond rates are exceptional and have raised the question as to why bond investors are willing to accept such low bond yields. Unconventional monetary policies (quantitative easing or QE) that push up the demand for bonds and thereby increase bond prices are usually seen as the major reason for the low bond yields (remember the negative relationship between bond prices and bond yields). Possible other reasons why bond yields are so low include the following:

Demographic changes in the developed world. There is is an increase in the demand for safe income-yielding assets, due to aging populations.

Currency gains. For foreign investors, expected currency gains (from the strong US$ for example) may compensate for losses on the bond itself.

Regulations and requirements. Some financial institutions must hold government bonds, due to capital regulations and liquidity requirements.

Negative inflation. Many developed countries experienced negative inflation in early 2015 and there was the expectation of further deflation. This implies that low and even negative nominal bond yields can still mean positive real yields.

Despite these low bond yields, investors have recently earned very favourable returns from bonds. For example, in 2014 the returns form the BlackRock Euro Bond Fund A2 EUR was 11.40%. As explained in chapter 14, the total returns from investing in bonds consist of two parts: the yield on the bond, or the periodic interest rate payments, as well as potential capital gains or losses (selling the bond before maturity at a price higher or lower than the purchase price). In 2014, falling bond yields was the consequence of increased demand for bonds, leading to higher bond prices and thus capital gains for bond investors.

Although it is possible that bond yields could remain low for some years due to very low global inflation rates, investors should not expect very low and especially negative bond yields to be sustainable over the long run. History has shown that average long-term nominal bond yields tend to be very similar to long-term nominal GDP growth rates. This means that global bond yields will at some point start to increase from the lows recorded in 2015. The result would be capital losses for investors who invested when bond yields were very low. Thus, investors should not expect recent capital gains and thus high total returns from bond funds to be sustainable. Investors should also remember that the level of the bond yield at the time of investment is the main factor in determining the return from the bond over the medium to long term.

Questions

1. Discuss some reasons for the low (and even negative) bond yields that prevailed at the beginning of 2015.

2. Discuss the sustainability of these low bond yields.

3. Discuss the relationship between bond yields and capital gains that can be earned when investing in bonds. In other words, explain why bond investors earned relatively high total returns on bond funds in 2014, despite the record low bond yields at the time.

4. Provide some reasons why bond investors were willing to accept negative bond yields in early 2015.