Returns from government bonds have matched that of equities in the past thirty years. Their risk adjusted returns are therefore superior. Bonds have been the stand out asset class during the Age of Disinflation that lasted from 1982 to 2012. We do not know whether we are arriving at an age of inflation but the ante-room to the next era is a period of normalisation. Part of the hallmark of that period will be a rise in bond yields.

We believe that core government bonds are overvalued at current yields. What measurements should an investor use that give a) a clear result b) are intuitively appealing and c) simple to grasp and use?

As we do not believe in the Fed Model which posits that there is some statistical or valuation linkage between bond yields and equity values, we need a way to think about absolute valuations. We have two ready reckoners to guide us.

The bond risk premium or BRP simply measures the term premium that holders of long term bonds receive over holders of short term bonds. Most readings over the past 30 years place this at between 0.5% and 1.0% but BRP is currently negative. As QE sought to flatten the yield curve, we would expect the winding back of QE to establish higher term premia, all other things being equal.

The rate of 10 year Treasuries corresponds to nominal GDP growth in the long run. On this basis a 10 year yield of 2.6% understates the long run growth rate and a yield of 3% would, in our opinion, be more appropriate.

On a bonds versus equities run-off, equities win based on expected total returns.

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