Bond Bulls May Yet Have Reason for Cheer

The bond-market limbo act goes on. At the start of 2011, bond-fund giant Pimco bet against U.S. Treasurys when the 10-year note was yielding about 3.3%. But Treasury yields ended the year under 2%, along with yields on German and U.K. government bonds, extending further a 30-year bull market for bonds. There might be further to go yet.

Central-bank bond purchases, known as quantitative easing, will play a part. While earlier rounds of QE pushed up yields on hopes that this would support recovery, repeat operations may have diminishing effects. In the U.K., yields have continued to fall despite a new £75 billion purchase operation. The Bank of England is widely expected to increase that program early this year, and many speculate that the U.S. Federal Reserve may engage in a third round of QE. Former European Central Bank board member Lorenzo Bini Smaghi has suggested that even the ECB could make use of the policy if monetary conditions demand it.

Such central-bank purchases may coincide with a reduction in the stock of securities still regarded as "safe" due to potential ratings downgrades in the euro zone. That could have a dual effect. Yields could be kept down as investors question the effectiveness of QE in generating economic growth. But buyers who have little choice about investing in bonds due to regulation may be forced to compete with central banks for paper.

Banks are being required to hold greater liquidity buffers. Central-bank reserve managers, particularly from Asia, are likely to remain core buyers of government debt. And despite deep concerns about the euro, many investors within the currency bloc have no choice but to invest in euro-denominated bonds. Even those struggling with the effects of low yields, such as pension funds, need to match assets with liabilities. Rather than shunning low-yielding bonds in countries like the U.K and Germany, funds that expected yields to rise may be forced to accelerate purchases to reduce the mismatch in their portfolios.

Many advanced economies are entering a multiyear period of paying down debt. That will likely weigh on growth and on domestic inflation, as it has in Japan, boosting the allure of government bonds over risk assets. This process may cause periodic outbreaks of panic about banking systems, as in 2011, driving yields lower. As the panic fades, yields may rise—but so far, they have risen to a lower peak each time.

This environment also creates a challenge for governments. Germany in November saw investors balk at buying new 10-year bonds at yields below 2%. But with two-year bond yields anchored at 0.3% or below by zero interest-rate policies, investors will have to buy longer-dated bonds to generate any return.

That means long-dated yields could go lower and for longer than many thought possible. Just look at Japan, where 10-year yields ended 2011 at 1%.

Source: http://online.wsj.com/article/SB10001424052970203550304577138101578099224.html?mod=WSJ_Heard_LEFTTopNews