Yields and volatility, that’s what’s up. And a long overdue realisation that very low or in many cases negative yields on government bonds represent very poor value. Here, I want to examine what caused the recent sell-off in bonds, ask if there is value in any areas of the bond market and how we are positioning our portfolios. 
The global government bond markets have experienced a torrid time of late, and frankly this does not surprise us. We have been underweight bonds for quite some time, and indeed have had no gilts in any of our income funds for a substantial period of time.
Gilts have been very volatile so far this year, rallying in January, selling off in February, recovering in March, then weakening dramatically from late-April.
Performance of indices over 2015
Source: FE Analytics
The recent weakness in bond markets really originated in the eurozone. Following the start of the ECB’s quantitative easing (QE) programme in early March (which was announced in January and included a bond purchase programme of €1.1trn with €60bn a month, which was slightly bigger than had been expected), European government bonds had continued to rally sharply in anticipation of this.
Indeed, 10-year German government bonds had traded to a yield of just 7 basis points, with a large proportion of the market by now trading on a negative yield. Thus bond markets had traded to very expensive levels and essentially bond investors rejected the ultra-low yields on offer.
There were three events that appeared to trigger a sell-off: figures were released showing a pick-up in German money supply growth, there was a poor German five-year bond auction and at their latest meeting the Federal Reserve seemed to downplay the weak US first-quarter growth number, suggesting a rate hike sometime after June was still very likely.
Hence eurozone bonds sold off sharply from late April and gilts followed suit. Sentiment was not helped by a prominent US bond fund manager stating that ‘German bonds are the ‘short’ of a lifetime’.
Perhaps more relevant, the chair of the Fed, Janet Yellen, said in early May that bonds and stocks were both richly valued and that there could be a sharp rise in yields on a Fed rate hike. The sell-off therefore gathered pace, with the market experiencing what could be described as a ‘mini taper tantrum’, reminiscent of the US bond market weakness back in summer of 2013 when the market fretted over the Fed tapering (i.e. reducing) their QE programme.
From late April to mid-May, 10-year German bond yields rose from 0.07 per cent to 0.72 per cent, a quite staggering sell-off. 10-year gilts were not far behind, with yields rising from 1.51 per cent to 2.02 per cent. Thus not only have government bonds sold off, but there has been a high degree of volatility, not a desirable feature of supposedly ‘safe’ assets. Indeed volatility in the gilt market has risen to the highest level for three years.
There have also been question marks over liquidity in bond markets, as the weight of regulations does at times seem to be limiting the ability of banks to provide liquidity to the marketplace. However, bond markets now appear to have stabilised, as some investors, having rejected the ultra-low yield levels, now see a bit more value in the market.
Specifically, there have been a few key supportive events. Firstly, the ECB strongly hinted that they could increase their QE bond purchases in the next two to three months (essentially front-loading ahead of the summer lull) which buoyed European bonds.
Secondly, there has been some weaker US economic data on retail sales and industrial production which has supported US bonds.
Lastly, the Fed minutes from their latest meeting were recently released and it virtually rules out a June rate hike. They expressed a little more concern over the softer US economic growth seen in the first quarter, where GDP rose just 0.2 per cent annualised (though this was affected by bad weather and some strikes at US ports).
What does this all mean for our positioning in bonds? While bonds now appear to have stabilised, which is a welcome development for equity markets, we do remain underweight in bonds as an asset class and in particular we still see no value in gilts.
We have a somewhat lukewarm view on investment grade bonds, but still have some exposure here as the shorter duration and credit spreads should provide some protection from any further weakness in gilts.
Sectors we favour are floating rate bonds, as these have very little interest rate sensitivity. We also retain exposure to what we term specialist bonds, which tend to be more specialist funds that contain bond-like instruments or characteristics. For example, within this sector we think there is value in areas like real estate debt, aircraft leasing, infrastructure debt, and residential mortgage-backed securities.
The bond sector we favour the most is high yield, as we see some value in the market following the weakness in the second half of last year. One reason for the weakness was that US high yield in particular suffered last year due to the fall in the oil price, as energy issuers are a big component of US high yield.
With more attractive valuations, and as oil appears to have stabilised, to our minds this has created a good opportunity, hence we have added exposure here. The ongoing demand for income should also be very supportive of high yield, with some high yield funds offering yields of 5-6 per cent.
We therefore see value in selective areas in the bond markets, but we believe gilts remain anything but risk-free, and volatility could remain elevated as the first US interest rate hike approaches.
Mark Rimmer is a product director on Premier Asset Management’s multi-asset funds. The views expressed above are his own and should not be taken as investment advice.
