Not that it is a comfort to fixed income fund managers, but it’s not only bond markets which are range-trading now – equity and currency markets seem to have adopted a similar rhythm, trading without too much conviction and somewhat nervously. “It’s about the only theme bonds, equities and the US dollar have to follow right now,” says Edwin Trieblnig, head of international bond Fund Management at Austrian asset management group Erste-Sparinvest. “There is essentially no real news from the macro (economic) side, markets are being driven by positions, and the bullish moves can be explained by short covering. Investors need to look at their charts and play these technicals. But, if you are going to trade this sort of market then you need to be intra-day, or else you will be stuck on the wrong side.”
“That’s the thing about range-bound markets,” agrees Martin Hueppi, executive vice president at Clariden Bank in Zurich. “It is vital that you continually check where you are. The market’s reaction to the figures is sometimes quite explosive, initially and then things revert back to the range. It’s easy to get whipsawed.”
“Like the majority of other investors in the US, according to the investor surveys at least, we are fairly underweight in terms of duration benchmarks,” says Audrey Behan of Bank of Ireland Asset Management (BIAM) in Dublin. “We suspect that, because of this range trading environment, a lot of investors have actually capitulated and gone more neutral. It’s not hard to understand why: yields are still lower than economically justified but the data, and particularly some recent figures, are mixed and actually question the perceived health of the (US) economy.”
But with official short rates still at such low levels and economies clearly still growing, it is hard to justify a bullish stance. “Valuations of bonds, especially in the US, are awful!” argues Paolo Bernardelli at Sanpaolo Asset Management. “Yields are now at a level that is compatible only if you believe that the current rate of economic growth is not justifiable and that inflation will remain subdued in the face of high commodity prices.” But Bernardelli then goes on to highlight the paradox facing bond investors: with the consensus/overwhelming majority being bearish and thus short duration, what will send yields higher with few sellers of bonds left?
From the macro-economic standpoint, Hueppi believes that it should not come as too much of a surprise that economic growth, particularly in the US, appears to be faltering. He argues that the bursting of the dotcom bubble did not precipitate a recession for the US consumer. He explains, “The downturn after the bubble burst was in effect a severe one for the corporate world, but the consumer wasn’t ‘damaged’ that much. And when interest rates cut lower and lower the consumer felt even better as he was able to cheaply leverage himself up. So the whole downturn was quite shallow as the consumer was able to remain quite strong throughout.”
Whilst that view may not be shared by the majority, the consensus chooses European (government) bonds in preference to US bonds. “We expect outperformance Europe,” says Behan. “Economic growth has, as we all know, been much more subdued and the European Central Bank (ECB) has yet to start tightening policy. And we believe that investors are less underweight duration on this side of the Atlantic. Yields will not be going that much higher. The growth in Europe has been only achieved through external forces and the domestic component has really lagged.”
Many managers appear to expect yield curve flattening to continue, more so in the US than in Europe. Of course Japan, where there is curve steepening, bucks the trend. Erste-Sparinvest’s Trieblnig suggests that the 5-year is the least attractive part of the curve, not least because it tends to react most to positive macro-economic news. “We prefer 5-30 year flatteners and the wings of the curve. But this is not to argue that the 2-year segment is a ‘safe’ haven. In fact we are bearish on bond prices in general especially when the US 10-year yield gets below 4%. In this environment, the 2-5-10 year butterfly represents the defensive play to us.”
Sanpaolo AM’s Bernardelli is also a proponent of this trade. “According to our market view – ie a trading range within a bear market – we prefer the butterfly: long the 2-year and 30-year and short the 10-year. We are long the 30-year sector because it normally outperforms the 10-year in tightening cycles and bear markets. And this bearish curve positioning is protected from a short market squeeze and excessive negative carry thanks to the long position in the 2-year sector.”
Credit markets, both in Europe and the US have maintained their lure in these climates and many investors profess to being overweight or to only recently having cut back overweight allocations. BIAM’s Behan comments, “We are neutral to overweight here and have recently taken some money out because credit spreads have come in so much since their 2002/2003 peak. We do still have allocation here because there is good fundamental news: the lower default rates; moderate growth; and the ongoing repair of balance sheets particularly in the telecomms.”
Bernardelli adds, “There have been two main themes driving the positive performance of the euro corporate market this year: one fundamental in nature; the other technical. Mainly, the rally was driven by the steady improvement in the underlying fundamentals of the companies.
They cleaned up their balance sheets by lowering their leverage with a policy of asset disposal using free cash flow to buy back or refund existing debt, rather than enhancing shareholder value. This phenomenon was perhaps most evident in the telecomm sector but was not confined to here. There has been a decisive improvement in the upgrade/downgrade ratio and this has helped maintain the positive mood in the market.”
The market has also received strong support from some technical factors, including declining net issuance coupled with strong demand from an increasingly diversifying investor base. Bernardelli suggests that the increase in CDO (Collateralised Debt Obligation) activity over the summer arguing has also been one of the drivers of the recent strong performance of spread products.