Viewpoint: Bonds at a tipping point

Volatility in government bond markets has risen sharply following Federal Reserve chairman Ben Bernanke's May testimony to Congress. Having fallen as low as 1.6% shortly before Bernanke spoke, 10-year US government bond yields are now trading at around 2.2%, levels not seen since the first half of 2012.

This is not the first government bond sell-off that we have seen in 2013, but critically the drivers of this one are different to those that we witnessed at the start of the year, when we saw 10-year US government bond yields top out at just over 2% in March.

At the beginning of the year, the market's confidence in the global economic recovery was reasonably strong and government bonds reflected this through increases in the level of expected inflation. This is measured by the so called "break-even yield" (the difference between the yields of nominal and inflation-linked government bonds) which in March suggested US inflation at around 2.6%.

Today, while government bond yields are again on the rise, the implied level of US inflation is just over 2%. The reason for this is that we have seen a sharp correction in inflation-linked bonds, whose yields have risen much faster than those on nominal government bonds. For the first time since 2011, 10-year inflation-linked bonds in the US now command a positive yield: in other words, 10-year US government bonds now offer investors a positive real yield.

So, while the outcome appears to be the same (higher government bond yields), it is clear from this analysis that the underlying drivers are not.

Cherry Reynard takes an in-depth look at the market's prospects in:Is there a bond bubble?

When Bernanke spoke to Congress, his words altered perceptions of US quantitative easing (QE) which, along with fears of deflation and financial regulation, has acted as powerful force driving bond yields to ever-lower levels. The current rise in yields reflects this change and represents a rise in the level of uncertainty surrounding the impact on US Treasuries should the Fed - in Bernanke's word - start to "taper" its QE programme.

QE has removed the "term premium" from US government bond yields for some time now and its restoration is potentially significant. In this context, the recent sell-off represents a return to a more normal situation and one that might persist, even if we think that fears of a near-term exit from QE are overdone.

We need to tread carefully in this environment. While the restoration of a term premium may continue to exert upward pressure on yields, other forces at work in the bond market continue to strain in opposite directions. This means that markets behave as if they are at a tipping point where changes in either direction, no matter how small, have larger effects than we might otherwise anticipate.

Investors need to take care with their portfolio construction and diversify away from government bonds where real yields still remain largely negative and into areas of the market that offer improving fundamentals that can be bought with a margin of safety, such as asset-backed securities and financials.

Where investors do own interest rate risk, they should look to sell extreme levels but be prepared to pare this back. With government bond markets at a tipping point, responding sharply to changes in the powerful forces operating in either direction, we might expect further such opportunities as the year unfolds.

Anthony Gillham is manager of the Old Mutual Voyager Strategic Bond fund.