Central banks continue to dominate sentiment in fixed income but recent events have shown the fragilities present in the bond market and investors need to keep a number of key lessons in mind, according to Old Mutual Global Investors (OMGI) fund managers.
Monetary policy remains closely watched by investors. Last month saw the European Central Bank (ECB) extend its quantitative easing programme by nine months to September 2018, although it did slow the pace of bond-buying to €30bn a month.
Meanwhile, the Bank of England announced a 25-basis points increase in the base rate but gave a dovish nod by validating the current market pricing of its rates outlook.
Elsewhere, Shinzo Abe’s re-election as Japanese prime minister implies that Bank of Japan governor Haruhiko Kuroda will remain in place, while Jerome Powell has been nominated as chair of the US Federal Reserve.
In their latest outlook, Old Mutual Global Strategic Bond fund managers Mark Nash and Nicholas Wall said: “It is hard to imagine a more dovish hand being dealt by central banks at this moment in time.
Performance of bond sectors in 2017 to date
Source: FE Analytics
“Yet the reaction in bond yields and credit spreads has not been supercharged. Developed market government debt has been range-bound, while many corporate and emerging market bonds are actually weaker. There are short- and long-term reasons for this; we believe the recent price action provides some important lessons for 2018.”
In the following article, we look at four issues the managers believe bond investors need to pay attention to.
When bond funds start to take to profits
Nash and Wall pointed out that most actively managed bond funds’ default positions tend to be long carry, in order to generate returns from yielding assets. When they start to unwind these positions to lock in profits will be important for bond markets.
They note that bond portfolios tend to be overweight corporate bonds and fund this position from an underweight sovereign debt position. Furthermore, they can buy high-yielding emerging market currencies versus a developed-market low yielder such as the yen.
“As we approach year-end, there will probably be a temptation to lock in these gains – in almost any asset class, consensus positions have been squeezed,” they said.
Watching ETF flows is now critical
The bond managers also highlight the rise of exchange-traded funds, arguing that asset allocators and retail investors are increasingly using them to gain beta exposure to more illiquid parts of the market like US high yield bonds and emerging market debt.
ETF shares outstanding (rebased)
Source: Old Mutual Global Investors, Macrobond, 15 November 2017
ETFs have now become so large that their flows have the power to move markets. Nash and Wall said this has created a “reflexivity problem”, where selling by ETFs essentially causes further selling.
“ETFs are essentially transforming illiquid parts of the market into instant liquidity securities,” they said. “This has worked wonderfully well so far, but we fear ETFs will disrupt markets in the event of a material change in investor sentiment.”
Market liquidity is an illusion
One notable feature of markets since early 2016 has been very low levels of volatility, which Nash and Wall argue are largely down to the sheer amount of money that has been printed by central banks.
Quantitative easing (QE) programmes across the globe have supressed real yields and helped companies and sovereigns to raise money very cheaply, while keeping volatility flat at the same time. However, the OMGI managers warn that this might prove illusory.
“Market makers have increasingly become conduits between corporates borrowing to buy back their own stock and the relentless buying of yield-starved investors – it is pretty easy to keep spreads tight in such an environment,” they said.
“In the last month, as companies issued into a selling market, the ability of that market to provide two-way pricing and warehouse risk evaporated, despite the central banks’ dovishness.”
Worry about QE trades unwinding
While the current monetary policy environment remains dovish, there are signs this will not last forever. The Federal Reserve has already unveiled plans to shrink its balance sheet while more hawkish members of the ECB have suggestion the recent QE extension will be the final one and the Bank of Japan has slowed its asset purchase plan.
“We believe this means higher yields and wider spreads are probable as QE trades go into reverse,” the bond managers said. “The investment world is not ready for this: it is structurally long carry and short volatility, and the intermediaries on whom sellers are relying to provide liquidity in an unwinding of these positions lack the capacity to do so.”
Performance of fund vs sector and index under Nash and Wall
Source: FE Analytics
Nash and Wall have managed the £137.1m Old Mutual Global Strategic Bond fund since August 2016, over which time it has generated a 1.37 per cent total return. While it has beaten its benchmark by a decent margin, it is lagging its average peer in the IA Global Bonds sector – although it has been one of the least volatile members of the peer group.
In terms of positioning, the portfolio is currently shorting core government bonds while owning inflation protection. Meanwhile, the managers have turned more cautious on credit and emerging market debt.
“Our funds are designed to outperform as inflation, volatility and yields all start to rise – price action we expect in an environment of ‘quantitative tightening’,” they added.
Old Mutual Global Strategic Bond has an ongoing charges figure (OCF) of 0.65 per cent and is yielding 0.91 per cent.