Long-term government bonds have been badly hit by expectations of economic recovery and falling investor risk aversion. Since mid-March, long-term government bonds have slumped with the yield on the 10-year bond increasing by 150 basis points (1.5%) and 75 basis points (0.75%) respectively in the United States and in Germany.

That government bonds have turned in such a poor performance may come as a surprise in an environment of weak economic activity, strong deflationary trends and short-term interest rates close to zero. This performance needs first and foremost to be put into perspective.

In the fourth quarter 2008, the deepening financial and economic crisis prompted an unprecedented flight to quality, with investors abandoning risky assets and taking refuge in government bonds, which pushed prices up and yields down.

Accordingly, the 10-year US Treasury yield fell from 4% to 2% between October and December 2008. (An investor buying this bond at the start of October at 100% could have sold it for 115% at the end of the year.)

In the first two months of 2009, risk aversion remained high which kept yields low. More encouraging economic data published after this period gradually began to convince investors that the world economy might pick up in the second half of the year, which prompted them to move out of government bonds in favour of more risky assets. Interestingly, the plight of government bonds did not affect the corporate bond market. On the contrary: corporate bond prices surged narrowing the spread between corporate and government bonds, which is currently quite close to levels observed before the collapse of Lehman Brothers.

While the poor performance of government bonds is in part due to cyclical factors, there is also a structural element involved. The measures taken by the authorities to combat the crisis will result in spiralling budget deficits and rising public debt. The financial markets are starting to fear a torrent of new government issues on the markets and the ensuing inflationary risks that could arise from the lack of budgetary restraint.

Regardless, following a bad run over the past few months, government bonds have returned to attractive levels again. The first reason for this are the structural problems I have alluded to on a number of occasions, linked to the process of deleveraging undertaken by households in the U.S. (and other Anglo-Saxon countries) and banks, which will continue to weigh on economic activity and thwart hopes of a strong and sustainable economic recovery. The more so since rising long-term rates are starting to jeopardise the stimulus measures implemented by the US authorities as they force up the cost of mortgages.

The second reason is that fears of a resurgence in inflation are at the very least premature. In the short term, the world economy is, on the contrary, facing strong deflationary trends as well as significant excess production capacity and a sharp rise in unemployment. As for the impact of deteriorating public finances, it is still too early to estimate whether this will have an inflationary impact. Much will depend on the reaction of the authorities once the economy begins a sustainable recovery.

As is the case with equities, an active investment strategy is more necessary than ever as far as bonds are concerned. Buying long-term governments bonds at current levels with a 6-12 month investment horizon should yield an attractive return for investors.