Bond yields and credit spreads

And what they can tell us

Sovereign bond yields and credit spreads are simultaneously the most watched and the most enigmatic of all macro indicators. For portfolio strategists, they signal risk-on and risk-off sentiment in the broader capital markets. For property investors, they anchor valuations—initial/exit yields and discount rates—as well as borrowing costs.

Bond yields have been on a persistently downward trend for several decades (p. 5), but short-term movements have often been surprising. No doubt trade tensions, divisive politics, civil unrest, wavering economic growth and central bankers’ actions will continue to make the bond needle flutter in November and December. The outcomes of geopolitical events can be especially hard to predict; with so much noise in the system, risk aversion is likely to remain high. Indeed, professional economists and financial markets alike have been notoriously poor at predicting the path for long-term interest rates (p 4). In our view, an underestimation of the linkages between demographic forces and savings behaviour could also be a contributing factor for the persistence of ultra-low interest rates. Ageing trends in many countries are a “meta” macro force that is easily overlooked behind the daily headlines of geopolitics, central bank announcements, and economic statistics.

The gradual decline in long-term interest rates is certainly linked to lower growth expectations. Weaker growth is generally consistent with less inflation, implying that bond investors require less inflation compensation. When productivity growth is low (as it is now), economic growth should be roughly proportional to working-age population growth across an entire business cycle. After a string of strong decades (1950-2000), demographic trends have moved from positive to neutral (2000-2020), and are now poised to turn negative in many countries. A recent study by the UK’s Office for National Statistics highlighted that their population projections had been too optimistic, as life expectancy gains have fallen back and fertility rates disappointed. Similar recent demographic trends are found in North America and Western Europe; demographics are already a net drag on national economic growth in Italy and Japan. Meanwhile, UN projections show that the slowing and greying trends in the world’s population are likely to be maintained or increased over the next century (p. 6). As such, economic growth, risk asset returns (stocks, corporate bonds and real estate) and inflation will all likely remain constrained. Post-Keynesian macroeconomic theory¹ did not contemplate the uncoupling of the money supply, inflation and consumption/investment behaviour, so central bank remedies have been hard to identify. Recent announcements by Mario Draghi as he steps down from chairing the ECB, by Jerome Powell at the US Fed, and by Kuroda-san at the Bank of Japan all point to the limitations of monetary policy when short-term interest rates approach the zero bound.

As populations reach retirement age, they turn toward low-risk, liquid saving rather than higher-risk, illiquid investing, pushing sovereign bond yields lower. Data from the IMF show that the globe’s total savings has exceeded investment since the turn of the century; their forecasts suggest that this imbalance is likely to remain. Moreover, developing nations save a much larger share of their national income than developed ones (pg. 7), due in part to less mature pensions and weaker social safety nets for the elderly. So, when the rising middle class in China, India, Central Europe, and Latin America generate income in excess of their immediate needs, surplus savings are generated faster than growth in stock markets or domestic consumption. The GFC’s scars may also be evident as investing with a long horizon is dampened by fears that economic conditions tomorrow could be worse than today. Thus, ageing populations imply an increased need to focus on liability-matching, capital preservation, rising liquidity preferences, and ultimately, de-cumulation strategies.

Demographic forces are like giant container ships that move slowly but steadily across great oceans. They cannot pivot or come to a full stop quickly. The demographics of ageing are likely to remain in play for many years to come, so real estate investors should keep in mind the following:

• Demographic themes have a major influence on the resilience of assets, sectors and locations. One approach is to focus on properties and locations that cater to the growth of specific cohorts (e.g., ageing, active adult populations or younger millennials). A subtler approach is to examine how younger and older cohorts interact over time, and how the locational preferences of different cohorts affect each other.
• Demographics also have a “meta” effect on macro factors like capital markets. Persistent downward pressure on risk-free rates could mean that real estate yields will decline further and remain below their previous norms. Lower for longer can become lower forever in ageing societies. Real estate’s ability to generate income will continue to attract institutional capital, particularly as populations (and pension schemes) mature. When sovereign bond yields fall or go negative, pension administrators and individual households will both turn to alternatives like real estate to generate steady income.
• Demographic trends are linked to both the capital markets and the space markets. Unlike economic and political events, population shifts get fewer headlines and move more slowly. Their influence on real estate investment strategies is often underestimated and well worth our close attention.