The World of Bonds – Do ‘Experts’ Suffer From “Round Number Bias”?

Date Published: 14 May 2018

Category: Investment

 

After the falls in some bond categories, are there some interesting opportunities?       

Alan MillerChief Investment Officer, SCM Direct, 14th May 2018

 

Recently, the JP Morgan CEO, Jamie Dimon predicted a rise in US Treasury yields from 3% to 4% pa.  I regard this as a classic example of “round number bias” which seems to inflict even the most intelligent people in the City.

“Round number bias” is, as it literally says, the human tendency to pay special attention to numbers that are “round” in some way.  The July 2005 US Accounting Review found that analysts who round their forecasts of earnings per share “exhibit characteristics of analysts that are less informed, exert less effort, and have fewer resources. Rounded forecasts are less accurate and the negative relation between rounding and forecast accuracy increases as the rounding interval goes from nickel to dime, quarter, half-dollar, and dollar intervals.”

Despite bearishness from many bond commentators, US Treasuries do not look out of place compared to the inflation rate based on the last 5 years of data (although admittedly real yields have been higher prior to this).  The chart below compares the US 10-year yield (blue line) vs inflation expectations (red line), and shows that the US Treasuries real yield (lower graph) is higher than it has been for most of the last five years:

Source: Bloomberg LP

Two assets in which we are invested, US$ Emerging Market Bonds and US$ Corporate Bonds, appear very undervalued after their recent falls.  US$ Emerging Market Bonds, currently offer yields of c. 5.7% pa.

The graph below shows a leading ETF that invests in this area, the iShares USD Emerging Market Bond ETF performance vs money flows and indicates investors tend to invest after outperformance and sell after underperformance.  This is often precisely the exact opposite of what normally makes money:

Source: Bloomberg LP

When you compare the yield premium over US Treasuries offered by these Emerging Market Government Bonds vs High Yield Bonds (formerly known as Junk Bonds), the position of the two has reversed – Emerging Bonds used to yield less than High Yield Bonds, they now offer more:

Source: Bloomberg LP

Also, one might expect local currency Emerging Market Bonds, to reflect the greater volatility and risk attached to emerging market currencies, to yield more than their equivalent $ denominated counterparts, but currently the exact reverse is true:

Source: Bloomberg LP

Meanwhile, US corporate bonds (shown in the blue line in the graph) offer significantly higher yields, c. 1.5% pa more, across all maturities as compared to UK corporate bonds (shown in the red line) or European corporate bonds (shown in purple line) – we use currency hedged ETFs in this area to access this extra yield without extra currency risk:

Source: Bloomberg LP

Whilst rounding is a lazy, somewhat attractive human reaction, it is always worth putting in the work as this tends to lead to better results for clients in the long term.

 

Please Note

The value of investments can go down in value as well as up, so you could get back less than you invest. Exchange rates may cause the value of overseas investments and income from them to rise and fall. It is therefore important that you understand the past performance is not a guide to future returns. SCM Direct does not give personal advice.

SCM Direct is a trading name of SCM Private LLP which is authorised and regulated by the Financial Conduct Authority to conduct investment business.  Company registered in England and Wales, no. OC342778.

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