Are we now simply witnessing a correction after markets overshot in the wake of the ECB’s bond-buying programme, or is this the beginning of a serious bond bear market as deflation worries have started to fade?
Omar Gadsby, head of fixed income fund selection at Credit Suisse’s private banking arm, is in the camp of those who think immediate downside in the bond market is limited. “I’m constructive on inflation remaining low, and I see no reason to change our overall view on the bond market,” he says.
Risk-off
Nevertheless, Gadsby and his team have been positioning their fixed income portfolios slightly more defensively, reducing their positions in both high yield bonds and emerging market debt fromoverweight to neutral and increasing his exposure to long/short bond funds to 20-30%. “Overall, we are reducing risk because I expect higher volatility. So we are moving from beta exposure to more active managers. This is going to be an alpha year as it is increasingly challenging to capture beta returns,” he says.
For Tim Peeters of the Belgian multi-family office Portolani, the bond slump proves there’s something fishy in the bond markets. “Even though the central banks continue stimulating, very small tensions in the market already have prompted price falls of more than 5% in a few weeks,” he says.
So Peeters is seeking refuge, increasing his already high allocation to absolute return bond funds even further. “Some 60% of my total fixed income allocation is now invested in this type of funds,” he says. Still, the Belgian fund selector doesn’t regard the current correction as a watershed moment. “It’s not yet the great sell-off which I’m expecting at some point in time. The big question is whether the ECB’s QE will continue beyond 2016.”
ECB to the rescue?
And it’s indeed the ECB which will continue to drive markets, Fabrizio Quirighetti, chief investment officer of Bank Syz & Co. in Geneva, told an investment conference in London on Thursday. “What happens today on the bond market is something the ECB doesn’t want to see. They want more volatility, but not in one direction as is the case now. So I expect Mario Draghi to say something to drive down yields again after the next ECB board meeting [on the 17th of June],” he said.
Though the drop in prices (see graph below) has made bonds look at least somewhat less expensive, they are still vastly overpriced, investors believe. This was illustrated by a poll at the Expert Investor Netherlands conference earlier this month, when 92% of delegates branded bonds as the most expensive asset class.
“Until this sell-off practically all bonds were in the 100th percentile in terms of historic prices. Now they are in the 97th percentile. It is absolutely astounding that anyone wants to purchase these assets now,” says Oksana Aronov, head of absolute return fixed income at JP Morgan Asset Management. “The risk-return profile for government bonds is still very poor,” adds Peeters. “I demand a yield of at least 2% in order to get back in.”
Pockets of opportunity
So where to put your money instead then? Apart from absolute return funds, which actually haven’t really managed to escape the recent bear market (see graph below), Peeters sees some opportunities arising in inflation-linked bonds. “I definitely see more perspective in inflation-linked bonds than in non inflation-linked bonds, to put it that way. Inflation expectations can probably only go up from here, so it’s worth considering to cautiously build up some positions.”
Despite having recently reduced his weighting to neutral, high yield bonds remain one of Omar Gadsby’s favourite asset classes. In one way, the low interest rate environment has brightened the prospects for high yield investors, he stresses. “Many issuers have been taking advantage of the low interest rate environment, extending their maturities. In the next two years, there will be only some $100bn in maturities, so very few issuers will have to repay the principal to investors. These low refinancing requirements underpin the current low default rates.”
A case for cash
Aronov of JP Morgan AM, on the other hand, is sceptical about the trend of bond investors moving into higher-yielding assets. “Investors are foregoing interest rate risk in exchange for credit risk, which comes with a higher equity correlation. However, people still expect diversification in their portfolios,” she says.
Though her portfolios are still fully invested today, cash is perhaps ‘the most valuable option’ now, she believes. “If the market is not paying you enough for the risk you take, go into cash, which is supposed to give you a return above inflation.” Besides, cash protects you when yields are rising. “It will be the first instrument to reprice when fixed income yields [and inflation] are rising,” she says.
