One of the most significant developments in global bond markets in recent years has been the collapse in term premium.The fact that the term premium is currently negative in Australia, and showing very little sign of heading substantially higher, is likely related to..
One of the most significant developments in global bond markets in recent years has been the collapse in term premium. Recently the Australian Office of Financial Management (AOFM) released a research paper looking into the Australian experience with term premium – which the AOFM defines as “representing the excess return investors demand for holding a longer-term bond as opposed to investing in a series of short term bonds.”
Measuring the term premium is not straight forward, as it cannot be directly observed but is estimated by decomposing bond yields into two components; the risk-neutral yield (based on the expected future path of interest rates) and the term premium (the excess return to compensate for uncertainty over the future outlook).
Wading through the mathematics of the AOFM report is hard work, but it is worth noting that the AOFM research relies heavily on the Adrian, Crump and Moench (ACM) model developed by economists at the NY Federal Reserve in 2013.
As can be clearly seen in the chart below, Australia is not alone in being impacted by this trend with the US (in addition to other developed bond markets) observing a significant decline in term premium over recent years and even turning negative.
10 year Bond Yields and Term Premiums in the US and Australia
Source: Bloomberg, New York Federal Reserve, Australian Office of Financial Management. Data to 31 May 2017.
So the big question is: what has caused the collapse in the term premium globally? The AOFM notes a few factors that could have caused term premium to decline:
- Changes in the degree of economic uncertainty (ie. future inflation)
- Changes in the required compensation for this uncertainty (ie. risk-aversion)
- Changes in liquidity
It is worth noting that the ‘flight-to-quality’ metric not only includes demand for bonds from investors, but also demand for bonds from central banks via their asset purchase or quantitative easing (QE) programs.
What is interesting is that the QE programs of the US, UK, Europe and Japan look to have not only had a strong impact lowering the term premium of their specific markets – but have also acted to lower the term premium in other bond markets, such as Australia, as well as the required risk premia of other assets, such as equities. This second order impact would be expected given the open and free flow of capital between these markets and the high foreign ownership share of Australian government bonds.
The sample period (1992-2016) used by the AOFM covers a secular decline in Australian and global bond yields. While both components of bond yields have driven this decline, it appears the largest contribution has been from lower risk-neutral yields. This aligns with recent research on lower neutral real interest rates (read our recent note for more details).
That said, the 2.76% decline in the term premium in Australia over this period is still significant and likely reflects the introduction of an inflation-targeting regime by the Reserve Bank of Australia (RBA) and the related reduction in the uncertainty of future inflation as the RBA built up credibility over this period. In the case of Australia, it is also very clear that the global financial crisis (GFC) caused a flight-to-quality that resulted in a shunt downwards in term premium in Australia.
The fact that the term premium is currently negative in Australia, and showing very little sign of heading substantially higher, is likely related to the persistently below-target level of inflation in Australia, continued flight-to-quality for Australian and global investors and the impact of global central bank asset purchases. We expect these factors to persist for some time to come.
Aside from a short lived increase in November 2016, coinciding with the US election and the following broad-based sell off in fixed income markets, term premium remains near historic lows. While there may be cyclical reasons to expect slightly higher bond yields in the future (ie. better economic growth and less monetary policy easing) term premiums are showing little sign of turning around yet.
But with the US Federal Reserve likely to begin reducing their balance sheet later this year (we think in September) and the European Central Bank beginning to discuss the possibility of tapering QE purchases early next year can we expect term premiums to remain so low going forward? Given term premiums are essentially excess returns to compensate for uncertainty, and central banks are doing their best to reduce uncertainty by offering very clear forward guidance, it seems the structural factors placing downward pressure on term premium could easily persist for some time.