The economic cycle is winding down, the geopolitical outlook is volatile and monetary policy has become paralysed by uncertainty. Is it any wonder investors are getting nervous?
In the face of these challenges, fund selectors have been seeking a safe harbour in one of the most unpopular asset classes of recent years: developed market government bonds.
European fund selector sentiment towards developed market government bonds – or ‘govvies’ – surged by 22 percentage points in the fourth quarter of 2018, according to Last Word Research.
During the final quarter of last year, the asset class was subject to the largest positive quarterly sentiment shift out of 26 asset classes. In terms of popularity, developed market government bonds jumped 11 places to 13th from 24th during Q4.
“Govvies become more attractive when the economy is turning for the worst and central banks are less likely to raise interest rates.”
“Govvies came up sharply in the December data, with around 20% of all respondents looking to increase their weightings over the next 12 months to December 2019, roughly matching the number of sellers,” according to the research.
“For the first time in the six and a half years of data collection, sentiment towards developed market govvies has become net positive and there are, on average, a few more buyers than sellers.”
Fund buyer net sentiment has increased rapidly since Q1 2017, and is currently in a low-neutral position.
According to Morningstar data, fund flows for the asset class totalled €13.8bn in 2018. Over the year, only three months experienced small outflows. In December, flows jumped to €3.7bn, just as there was a large sell-off in global stockmarkets. During this time the S&P 500 fell by 9%.
Paradigm shift
According to Kelly Prior, investment manager at BMO Global Asset Management, the divergence in central bank policies – the US Federal Reserve hiked rates four times last year while the European Central Bank maintained its benchmark rate at zero – has encouraged investors to reassess value in government bonds.
“People are becoming more nervous about the economic outlook and obviously government bonds are a sort of safe haven at times of uncertainty,” she says, encouraging the surge in flows late last year.
“Govvies become more attractive when the economy is turning for the worst and central banks are less likely to raise interest rates,” she says.
JP Morgan Asset Management global market strategist Mike Bell says, as we enter the late stage of the economic cycle, some investors might start to batten down the hatches ahead of the next recession.
Another prolonged downturn could prompt the Federal Reserve to slash rates to very low levels and even restart quantitative easing programmes, according to Bell.
“[Such a scenario] would make developed market government bonds look more attractive, particularly in the US, because it is one of the few major economies to have room to cut rates if the global economy heads into a recession in the next few years.
“Adding US duration into portfolios as a hedge to equity portfolios is increasingly making sense to many investors,” he says.
Playing favourites
According to Last Word Research, almost all users of developed market government bonds in Luxembourg and France expect to add to their allocations over the 12 months to December 2019, whereas the Finns and Belgians are not keen.
French selector sentiment towards the asset class skyrocketed in Q4 2018 from the previous quarter, becoming the most popular asset class from 23rd in Q3 2018.
Similarly, Luxembourgers are also putting their faith in the asset class. Govvies also jumped into the top spot among Luxembourg fund selectors in Q4 2018, from a lowly 22nd out of 26 in Q3 2018.
Luxembourg-based BIL Manage Invest head of financial assets portfolio management Giulio Senatore says he is looking to increase his allocation towards the asset class to hedge his tail risk.
“We want to construct a portfolio that takes into account tail risk by the equity market by adding developed market govvies and gold as they are less correlated to markets,” he says.
“In the past we avoided government bonds because we didn’t want to take on duration risk when interest rates were rising. Now that we don’t expect interest rate hikes we are less afraid of duration risk and therefore we think developed market govvies are a good hedge strategy.”
Amilton Asset Management diversification manager Lucas Strojny shares the view that as central banks start quantitative tightening there will be a normalisation of the asset class as well as diversification benefits.
“Last year, the German bund was a real diversifier for the portfolio and one of the few assets that have been positive, so we’re looking for these kinds of things,” the Paris-based fund selector says.
The best of the bunch
However, Prior and Bell both believe German bunds are not as attractive as US treasuries. At the time of writing, German 10-year bund yields had fallen to 0.13% – a near-two year low.
“Recent European economic data has not been great. However, there are signs the European economy is stronger that current numbers suggest,” Prior says. “As a result, rates could rise, bunds could be mispriced and people could lose money.”
Prior adds that it’s important for fund selectors to look beyond govvies as a collective asset class and focus on which developed market to invest in and how far on the curve they are going to lend.
Bell says investors could get better yield on more peripheral government debt such as Italian sovereigns but must be careful as the eurozone slows. Recent data suggests Italy entered a technical recession last year.
He says: “There’s risk in owning government bonds in core eurozone countries, like Germany and France, as well as Japan because yield is low, and there’s risk in government bonds in parts of southern Europe where debt to GDP is high.”
Strojny says he is playing a spread between 10-year Italian and French government bonds.
Prior adds that Australian government bonds could be an interesting play as the Reserve Bank of Australia is more likely than the US Federal Reserve to cut rates and create opportunities for investors.
Selectors prefer US bonds
Both Strojny and Senatore plan to increase their holdings of US treasuries. The Federal Reserve kept rates steady at its January meeting suggesting a shift in policy after tightening since 2015. In response to a more dovish stance from the Fed this year, Stojny says he will up his US treasury allocation via derivatives.
Senatore says he prefers futures or direct investments and is looking for a seven to 10-year duration for his US treasuries.
Bell cautions that European investors buying US treasuries need to monitor currency fluctuations and hedge currency risk.
“You give up a large part of the yield in hedging costs if you buy US treasuries at the moment, but it’s not a problem with longer-dated treasuries,” he says.
“If you buy a US 10-year treasury – or longer – you’re not buying it for the fact it’s got a 10-year yield of 2.75%. You’re buying it in the hope the yield will come down when the economy goes into a recession and interest rates are cut so you’ll benefit from the capital appreciation on that bond.”
Passive warning
Prior adds that selectors should be careful when buying passive vehicles in the government bond space.
“Passives in fixed income represent the amount of debt in the market, not the size of the economy. The largest element of an ETF [exchange-traded fund] is the country with the most debt,” she says. “You have to ask yourself what you want exposure to. If you buy a standard European government bond ETF, the largest component will be France (25%), then Italy (23%) and Germany (16%).
“If you buy a global government bond ETF, the largest component is the US, then Japan. Australia won’t be included and it’s arguably a place where you can make money.”
According to Prior, selectors must choose managers who can be tactical in the space and are able to look through the noise and spot opportunities.
Flexibility and open-mindedness is key, she says.
Complementary assets
At this late stage of the economic cycle a balanced portfolio should have some equities, US treasuries (hedged if necessary), some longer-duration US treasuries if the Fed looks to cut rates further, some cash and alternatives, says Bell.
“One part of a portfolio that makes sense is targeted absolute return strategies, which have the ability to hedge out market risk to make money no matter what is happening to equity markets,” he adds.
“I would look to increase those alternative allocations as they have a bigger toolkit than an average fund.”
While absolute return funds returned poorly last year, Bell says it was ultimately about picking the right funds.
He notes that infrastructure investments could earn high income to help buffer total return if capital value declines and that gold is also starting to make sense as it historically does better when interest rates available on cash came down as central banks cut interest rates.
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