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"If you thought it was bad, it’s actually worse": Brookes warns of bond correction in two years

03 December 2015

The Schroders head of multi-manager says investors will feel the effects of low liquidity in bond markets in the not-too-distant future.

By Gary Jackson,

Editor, FE Trustnet

Investors in the bond market are very likely face a significant correction within the next two years, according to Schroders head of multi-manager Marcus Brookes, who argues that conditions are much worse than many might suspect.

The manager, who runs Schroders’ Diversity range with Robin McDonald and Joe Le Jehan, has held a bearish stance on fixed income for some time but believes that the environment has become so adverse that the asset class is best avoided for the most part.

Brookes points to issues such as historic low yields in some part of the market, a worrying decline in liquidity and relatively high correlations with equities as some of the most pressing issues for bond investors.

“You really are, in my opinion, picking up pennies in front of a steamroller by buying bonds with low yields in the belief that the risk-free rate will stay low, you can take a bit of spread and when you want to sell them, it won't be a problem,” he said.

“Actually, if you want to sell your bonds at the same time as everyone else, this really could be a problem.”

Primary dealer positions of corporates, municpals and commercial paper

 

Source: JP Morgan Asset Management, as at March 2015

The above graph shows the changes in outstanding corporate debt (indicated in blue) and dealer inventories (indicated in green) since 2001.

Dealer inventories is the stock of bonds owned by banks and other institutions to sell to buyers. As there are no exchanges in the fixed income market, inventories are a key determinant of liquidity and lower inventories mean that buying and selling bonds is becoming more difficult.

“The bond market has doubled since the crisis yet actually dealer inventories have dropped 85 per cent,” Brookes.

“That data is all outstanding debt but when you look at just investment grade dealer inventories that's now gone negative. Banks are now taking liquidity out of the market rather than adding to it. They are now customers and are holding onto bonds, rather than trading them.”

“If you thought it was bad, it's actually worse than you thought it was. It doesn’t matter at this moment in time because markets are OK, there's no shocks and no expectations of a recession, but this thing will come to roost at some point in the next two years. I just don't know exactly when.”

Added to the manager’s above worries are concerns about how effective bonds are in offering diversification to a portfolio. While the asset class has historically been inversely correlated with the equity market, the two have been moving broadly in line more recently.


 

During 2015, for example, gilts and UK corporate bonds rose at the start of the year at the same time both UK and global equities were rising, before falling when concerns over China’s economic health spooked investors in the summer.

Performance of indices over 2015

 

Source: FE Analytics

Brookes said: “We’re all told that when we're constructing portfolios that equities are good over the longer term but you have hold bonds as well because equities will essentially halve at some point in every cycle.”

“One of the things we need to recognise it that diversification using just the standard old theory is not working in balanced portfolios as much as it used to. There has been no differentiation – every flavour of bond has done the same thing and unfortunately that was the same as what equities did.”

While some investors may argue that they are holding emerging market debt and high yield bonds in a bid to avoid the perceived problems in the sovereign and investment grade fixed income markets, the multi-manager points out that these assets always more highly correlated to equities and so offer no real defence.

Because of all this, Brookes continues to have a bearish view of the bond market and has minimal exposure in his portfolios.

Within the flagship £1.2bn Schroder MM Diversity fund, there is a 10.2 per cent allocation to fixed income but this is taken through Bill Eigen’s JPM Income Opportunity Plus and, as we have noted on a number of occasions, this is one of the more bearish managers in this part of the market.

The fund, which resides in the offshore universe, currently has 24.6 per cent of his portfolio in cash as he has a negative view on many types of bond. While this cash weighting may seem, the manager has actually been bringing it down recently – it was up to around 70 per cent at one point.


 

Around a year ago, Eigen told FE Trustnet that there will be “devastation” when the Federal Reserve starts to lift interest rates, adding that he was the most nervous he’s ever been in his 24-year career of managing fixed income assets.

More recently, Eigen warned on the outlook for developed market government debt by saying that ultra-low global yields and weak market liquidity are likely to spell significant problems for bond investors when central banks finally start of normalise policy.

“With the Federal Reserve moving towards an interest rate hike and the dramatic reduction in trading capacity, investors need to redefine what constitutes value and safety as well as when and how to deploy capital into markets distorted by multiple rounds of quantitative easing,” he said.

“To negatively impact the market price-insensitive buyers do not need to turn into sellers, but simply decelerate their rate of purchases. We don’t pretend to know what trajectory central bank policy globally will take and think it is extremely precarious for investors to link an investment strategy to the words and promises of central bankers.”

FE Analytics shows that Schroder MM Diversity has made a first quartile 70.59 per cent total return since launch in September 2005, while its average peer is up 48.89 per cent. However, performance has been held back over more recent time frames because of his avoidance of bonds – which have performed strongly on the back of loose central bank policy.

Performance of fund vs sector since launch

 

Source: FE Analytics

The fund has clean ongoing charges of 1.26 per cent.

 

Gary Jackson was recently a guest of Schroders at a conference in New York.

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