While this decompression will have been welcomed by investors looking to buy into the market, it was the opposite for those at the long end of the curve, with10-year bond holders losing around 5% of their capital.
Though the price shift made the headlines, rather than coming as a great surprise it has merely served to underline the dangers lurking the sovereign bond market, with investors struggling to identify a single decisive factor behind the sudden movement.
“There did not seem to be a key event leading to the bund fall,” said David Cavaye, chief investment officer at C. Hoare & Co. “It was more a collective market realisation that perhaps prices had moved to extremes.
“It was a combination of things. There is a general feeling that with energy prices having increased again perhaps inflation will start to come off the very low levels it has been at. Also, in bond markets there is a feeling that yields have just got too low.”
Investors are already concerned by how the upswing could resonate throughout the bond market, and, with US and UK interest rate rises on the horizon, the outlook for mainstream sovereign debt remains bleak.
“It will be quite a long time before interest rates go up in Europe, so we will have low yields for a while,” Cavaye expanded. “If inflation comes through then we might get a bit of steepening.
“However, even looking at it conservatively, in the UK interest rates are likely to be increased over the next year and then we might get further flattening of the curve if inflation expectations don’t increase much. At the moment we are seeing a great deal of volatility in bond yields, because yield returns are at such low levels it can make movements of even a few basis points seem quite dramatic, particularly in Germany.”
He continued: “Ten-year-plus yields in Germany could remain below 1% for a while, but you have to consider where and when interest rates are going to peak out in Europe, and people have not really thought much about that yet.
“With US rates peaking at 3.75% according to the Fed dot plot, well above market expectations, and UK expectations getting up to 2.5% by 2018, it looks to be such a long way into the future. No one expects European interest rates to go up at all for quite some time.”
There is still some scope for buying in the bunds, gilts and treasuries space, though investors should remain on the short-duration side, as Investment Quorum CIO Peter Lowman explained.
He said: “As far as sovereign bonds are concerned stay short, such as one-to-five years, and do not go out to the long end because if rates do go up it is looking pretty pricey and it is a long way down to par.”
“We do not own any European sovereign bonds,” Cavaye added. “We have some US treasuries in the high-risk portfolio, but they are short-dated and are a dollar play more than anything else. We also have some UK gilts, which have duration of around five years.”
With low yield levels looking set to continue in the mainstream space, fixed income investors are finding themselves having to venture further afield in search of sovereign bonds worth buying.
Luca Paolini, chief strategist at Pictet Asset Management, favours emerging market government debt, an area he believes will prove to be an incidental beneficiary of the central banks’ respective quantitative easing respective policies.
He explained: “With yields on benchmark government bonds at unsustainably low levels, the continued monetary stimulus provided by central banks worldwide should disproportionately benefit areas of the fixed income market where valuations are either close to or below fair value.
“Valuations for US dollar-denominated emerging market debt are clearly at odds with sovereign borrowers’ credit credentials. With the exception of Ukraine and Venezuela, there is nothing to suggest sovereign borrowers are finding it more difficult to service their external debt even if emerging market growth remains sluggish.
“The market’s aggregate yield spread is one standard deviation higher than what we consider to be fair value, while supply and demand dynamics should also support the asset class.”
How to play it
The consensus appears to be that the best policy is to cast your net as wide as possible in order to generate income, as Cavaye explained.
“Investors should look at funds that have an active, tactical style and are able to move quickly from high-yield to investment-grade to government bonds to manage risk depending on circumstances,” he said.
“We are still happy to have hold strategic bond funds which have a go-anywhere style and have some exposure to the high-yield area. The yield spread being offered is still reasonably attractive and a lot more than investment-grade.”
“However, we are somewhat concerned about potential liquidity in the bond market given the withdrawal by many of the investment banks, and have decided to reduce our weighting to about 5% in credit overall in our lower and medium-risk portfolios.”
Nick Gartside, international CIO for JP Morgan Asset Management’s fixed income group, holds a similar view.
He said: “In a flexible bond fund we would have a very low duration, around two years, and a very low cash balance as well. We would want a blend of high-yield, corporate bonds in areas such as financials and other investment-grade bonds, emerging market bonds and some mortgage bonds.”
And for investors that are seeking to protect their capital as opposed to taking on risk?
“In the current market, with 2% yields and zero interest rates, if you are looking for protection rather than fixed income, the best line of defence is index-linked funds,” said Lowman.
“Although inflation looks lacklustre at the moment, we might see some wage inflation creeping in during the second half of the year, which could spark a bit of an inflationary pull. Also, floating-rate note funds are going to benefit from rate hikes.”
Lowman went on to outline a selection of funds that he believes are well-equipped to hold up in the current climate.
“The Henderson Strategic Bond Fund runs a tight asset allocation and is a steady performer,” he said. “The M&G Global Macro Bond Fund is active in fixed interest market instruments that generate a total return and a tries to play macro themes. Another place one could park their money is M&G’s Index Linked Bond Fund, which is steady, slow-burner.”
The global bond trade is worth $100tn versus the equity market’s $30tn, and the opportunity set within the debt spectrum is huge, but, with yield proving increasingly elusive, fixed income investors are having to take the hunt even further afield.
So whether you are adventurous or cautious, balancing risk or simply sheltering capital, it appears that the only way this unpredictable bond environment pays is if investors spread their fixed income bets.
