Volatility has stalked the fixed income markets over 2015 and turned many sour on the asset class, but JPM Morgan Asset Management’s Bill Eigen says his defensively positioned fund is preparing to put money to work as the market approaches “more extreme” conditions. 
Eigen, who manages the $6.4bn JPMorgan Investment Income Opportunity and $435.1m JPM Income Opportunity Plus funds, has built up a reputation of being somewhat of a bear on his asset class thanks to his distrust of central banks’ unconventional monetary policy.
JPMorgan Investment Income Opportunity currently has 38.8 per cent of its portfolio in cash, but this weighting has approached around 60 per cent in the recent past.
The manager has also been vocal in his warnings on the health of the bond market. In December, he told FE Trustnet that there will be “devastation” within the fixed income world this year when the Federal Reserve makes its first rate hike.
“We are getting to a point where it is really dangerous in the bond market. It’s not funny anymore. I look where rates are, I look where economic fundamentals are and I look what central banks have done to these markets and I am the most nervous I have been in my career,” Eigen said.
He also warned that this market correction could be worse than the crash seen when the Fed lifted rates in 1994 and argued that many bond funds will end up suffering double-digit losses when this happens.
Performance of index during 1994
Source: FE Analytics
Recent months have seen a significant sell-off in bonds, with eurozone government debt being one of the worst hit areas. German bunds, for example, saw yields move from 0.07 per cent to 0.72 per cent in a matter of weeks.
However, amid this turmoil Eigen has been investing his cash pile and plans to make more use of it as conditions in the market reach more extreme levels, through shorting some bonds and going long on other value opportunities.
“As volatility levels in the bond markets have moved higher, our allocation to cash has moved meaningfully lower as we deploy that cash. Previously our high cash holdings reflected our priority of capital preservation and hedging in an environment of limited opportunities, but today we stand ready to capitalise on a rapidly shifting opportunity set,” he said.
“As we see markets approaching more extreme conditions, we are assembling our shopping list. Rather than potentially being forced to sell securities into a poor market in order to meet redemptions, we will instead be well positioned to utilise liquidity when it becomes extremely valuable.”
“For example, we may first look to do this in the credit default space, which historically tends to be sensitive. We would consider taking off synthetic hedges that have significantly outperformed, effectively making us longer on the markets. We would then opportunistically add to credit default swaps where opportunities arise and then target relative value opportunities in cash bonds where relationships may become disjointed.”
However, not all fund managers are convinced that the Fed’s rate rise will lead to severe trauma in the fixed income market.
Pictet Wealth Management’s Christophe Donay recently argued that the Fed and other central banks have the market’s reaction to their monetary policy moves firmly in mind and are likely to move more cautiously than most investors expect.
“Central banks will be keen to avoid a sharp rise in long-term interest rates, as this could derail the economic recovery by pushing up financing costs. We therefore expect a progressive and gradual rather than a sharp rise in long-term interest rates – although volatility is likely to remain high while rates slowly adjust to fundamental levels,” he said.
“We believe that, in the absence of an unforeseen external shock, the Fed will raise interest rates this year, probably in September. However, we think that the change will be only one-eighth, rather than a quarter of a percent as generally expected. Central banks will be keen to avoid turbulence on financial markets as this could derail economic recovery.”
Donay argued that government bonds still have a place in diversified portfolios despite their expense, pointing out that they maintain a negative correlation with stocks and “remain the best asset to protect portfolios against a shock to equity markets”.
Eigen, on the other hand, stands by his view that bond markets are heading into a period of significant difficulty and says zero interest rates mean large parts of the asset class can no longer deliver the capital preservation, income, and diversification benefits they traditionally have.
Performance of indices over 7yrs
Source: FE Analytics
“The heat in the bond market pressure cooker may be starting to reach a boiling point. Following years of artificially elongated global yield compression, it would appear that pressure valves are beginning to give. We have seen this in the German sovereign bond market over the last two months, when the velocity of yield spikes in 10-year bunds equated to double-digit price losses for investors in a matter of days, proving that the asset class is anything but risk-free,” he said.
“As investors start to realise the limitations of global central banks in maintaining complete dominance over fixed income market pricing, the razor thin margins of safety in bonds are becoming evident. At these extraordinary low levels, even relatively small moves in rates have the potential to wreak havoc on investors who have become too complacent with the asset class.”
This doesn’t mean the manager has been able to find any opportunities, as evidenced by the recent reduction in his cash position and his adherence to an absolute return strategy.
An example is the sell-off off in US high-yield debt that followed the collapse in the oil price last year and resulted in “attractively low prices” in the asset class. Eigen invested in high yield energy bonds – which had sold off indiscriminately – through traditional cash bonds as well as short positions through credit default swaps.
Over the course of 2015 high yield energy bonds are up nearly 7 per cent and have outperformed the broader high yield sector, which has gained around 4 per cent.
“Today’s fixed income markets call for an absolute return investment approach,” Eigen concluded.
“That means having the ability to be tactical and selective in exposure to interest rate and credit risk, to be able to access non-correlated sources of return, to take a systematic approach to hedging in order to mitigate drawdowns and manage risk with a focus on capital preservation, and to construct portfolios that can produce returns no matter what the market scenario or cycle.”
