Shot in the dark

Bond turmoil signals new era of return-free risk

US and German government bonds are gyrating as they rarely do. Yields are shooting higher for no apparent reason, and sometimes falling back within hours for equally unclear motives. Such turbulence in the biggest and most liquid bond markets is ushering in a new era. The traditional concept of risk-free returns has been turned on its head.

Ten-year Bund yields have multiplied by 16 times, to a high of 0.80 per cent on May 7 from 0.05 per cent on April 17. And German bond prices, which move inversely to yields, have suffered a larger drop than in 99 per cent of the three-week periods of the last 25 years, UBS Wealth Management strategists calculate. Meanwhile, comparable US yields have risen by more than a quarter in less than four weeks, peaking at 2.37 per cent.

The brutal moves are creating what Jan Straatman, global chief investment officer at Lombard Odier Investment Managers, calls "return-free risk". Investors have two problems as a result.

The first is sharply practical. Safety has become expensive, or less safe. Holding cash in the form of a rock-solid currency, such as the Swiss franc, is punitive, since policy interest rates are close to zero, or even negative. Gold is supposed to be a solid store of value, but the price is in thrall to the dollar's volatile exchange rate. And now US and German government bonds are looking risky.

These days, the hunt for safety is not a big theme for most investors. They would rather take some risks in return for higher yields. But that brings up the second problem with the new era. High turbulence in supposedly safe bond markets complicates the pricing of risk.

The standard asset pricing model relies on a benchmark risk-free interest rate. Riskier investments - from corporate bonds through shares to artworks - are supposed to promise a probable additional return in exchange for additional uncertainty and price volatility. The model is like a compass pointing in the direction of the right price. But this compass goes haywire when safe debt becomes extraordinarily volatile. Investors are left at sea.