Investors who are hoping that the second half of 2015 will be less volatile for bond markets need to prepare themselves for further ups and downs, says M&G head of retail fixed interest Jim Leaviss, who warns that the coming six months could be “equally frenetic”.
The bond market has been under heavy scrutiny over the past few months, following a strong sell-off that left holders of some ‘safe’ government bonds with losses. As the graph below shows, the average bond fund has struggled to perform against this backdrop.
Performance of sectors over 2015
Source: FE Analytics
Several issues have been cited as reasons for the turnaround in investor sentiment, including signs of stronger economic growth, a pushback against negative rates in some parts of the bond market and the likelihood that the Federal Reserve’s Federal Open Market Committee (FOMC) will lift rates at some point this year.
Looking back over the previous six months, Leaviss said: “The year started off with a bang, or rather a break, when the Swiss National Bank announced the surprise abandonment of the peg with the euro. This was only a mere week before the European Central Bank [ECB] embarked upon an historic quantitative easing programme. Deflation took hold in Europe, government bond markets rallied to historic lows, and the US Federal Reserve did nothing.”
“Fast forward to today, and it seems like we have lived through a full market cycle in only six months. Government bond yields have risen as the European economy has improved; the Greece political situation has also weighed on investors’ minds. In the UK, we had a surprise result in the general election as investors granted the Conservatives a majority in parliament. And in the US, the undeniable strength of the US labour market may finally be translating into higher wages, leading many to expect the first FOMC rate hike since 2006.”
But for any investor who thinks all this action means the bond market can look forward to a relatively calmer end to the year, Leaviss added: “While it may feel like 2015 can’t yield too many more surprises, in reality, the second half of the year could yet turn out to be equally frenetic.”
With this in mind, we look at how Leaviss is viewing three major factors sent to influence the direction of the bond market over the coming months.
Fed rate rise
All eyes are currently on the Federal Reserve, which is widely expected to make its first interest rate rise since the financial crisis in September. Leaviss agrees that there are strong arguments for the central bank to lift rates from their historic lows but says the picture is not entirely clear-cut.
“The Fed is facing a quandary. After more than six years of close to zero interest rates, it would dearly love to begin hiking, giving it the luxury of having both a brake and an accelerator when setting policy,” he said.
“A number of developments over recent months – namely the rally in equities, the growth in the sub-prime auto loans market, and the return, more generally, of structured credit – worryingly resemble the period 2003-07, during which the Fed kept rates too low.”
Performance of index over 2015
Source: FE Analytics
He notes that wage growth in the US looks to be improving with official figures showing US wage inflation stood at 2.6 per cent in the first quarter of 2015, up from 1.8 per cent one year earlier. This suggests inflation could start to move upwards.
Indicators such as this, corporate hiring data and the number of employees quitting their jobs are important to Fed chair Janet Yellen and the rest of the FOMC, as the central bank has a dual mandate to achieve stable inflation and maximum employment.
“Based on the bullishness of these indicators, a rate hike should soon become a reality,” Leaviss said. “But Yellen and the Fed remember the lessons of the Great Depression well – remove stimulus too soon, and a rapid descent back into recession could be on the cards. The Fed is left gambling that it will be easier to fight inflation by hiking rates than combating deflation in an already zero- bound world.”
Europe
Another issue driving sentiment in the bond market this year has been the ECB’s move to embark on full-blown quantitative easing. In January, the central bank said it would pump at least €1.1trn into the economy in a bid to fit off deflation in the currency bloc.
Leaviss says the region’s policymakers seem to have “followed the exact path” needed to generate deflation in the first place by essentially doing the opposite of Japan’s Abenomics stimulus programme.
Over recent years, policy decisions have significantly shrunk the eurozone’s balance sheet, implemented extreme austerity in troubled periphery nations and brought around slow structural reform, hampering the region’s ability to grow or fight deflation.
Performance of index over 2015
Source: FE Analytics
“But there is now – finally – some good news, with the introduction of potentially limitless QE, the likelihood of less fiscal austerity to come, and some small signs of structural reform. Regarding the latter, Italian prime minister Matteo Renzi has to date struggled to make much progress with his ambitious reformist agenda, so any advancement here could prove significant,” Leaviss added.
“The potentially even better news is that the ECB’s programme of asset-backed securities purchases has not really begun yet. This may take time to pick up speed, but if it does so, it should provide a good way for banks to get stale loans off their balance sheets, by repackaging them and selling on to the ECB at a profit. This should, in turn, support bank profitability, shrink banks’ balance sheets and enable new loans.”
Although the ECB’s programme is still in its early days, the manager points out that the eurozone left deflation after four months of negative inflation numbers. He says short-dated government inflation-linked bonds look good value in this part of the market, despite their recent rally.
Liquidity
M&G’s fixed income team has been discussing the issue of bond market liquidity for several years now and Leaviss points out that concerns over this have only gotten worse in recent months. Bond market liquidity has fallen for several reasons but especially because the new regulatory environment means investment banks can no longer act as the market makers they once were.
“A lack of liquidity in and of itself is not necessarily something to be feared, as long as an appropriate level of liquidity management is observed. Liquidity risk is often misunderstood: a bond could be defined as perfectly liquid, should an investor be prepared to sell at a significant discount. Instead, we define liquidity as the ’cost of immediacy of trading’, that is, the ability to execute trades at a reasonable market level,” the manager (pictured) said.
“Like all risks, investors can be rewarded for accepting liquidity risk, charging a premium that can be attractive in today’s low-yield environment. In fact, we see significant value in doing so in certain segments of the markets. In our view, investors in BBB-rated corporate bonds are being paid well in excess of the liquidity and default premia that we feel investors can demand for the risks involved in lending to these investment grade-rated companies.”
Leaviss adds that bond funds can mitigate low liquidity levels with a number of measures, including holding government bonds, short-duration high-quality corporate bonds or cash. Other options include owning the most frequently traded assets or using derivatives like credit default swaps and futures.
