Sovereign Bonds: Yielding more questions than answers
Some see recent bond-market sell-offs as the start of the long-awaited bear market in bonds – or at least a ‘normalisation’ of rates. Others point sceptically to weak global growth. Joseph Mariathasan asks what the dickens is going on
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us.”
Charles Dickens’ evocation of post-revolutionary France in A Tale of Two Cities will have a familiar ring to the bond investors of 2013. In a market rigged by central banks – some say wisely, others say foolishly – does a sharp rise in yields presage the end of the 30-year bull market for ‘risk-free’ sovereign bonds? Or does it just represent the volatility associated with a re-rating of prospects for global growth, and therefore an anticipation of future low, perhaps even record-low, nominal yields? Are those moves purely technical, driven by unwinding carry and momentum trades; or are they fundamental, driven by anticipation of a healthier US economy and resultant ‘tapering’ of QE; or are they driven by fears of disinflation and the stagnation of global growth? Bond yields should be a forward indicator of the health of the global economy. Unfortunately, interpreting their movements is more akin to examining the entrails of a sacrificial animal than analysing the data from a high-tech medical facility.
The 30-year bull market in bonds is a sequel to the bond bear market of the 1960s and 1970s for those few market participants with long enough memories. Fixed income fund managers may have analysed the last five, 10 or even 20 years, but rarely the decades before that, observes Robert Tipp, chief investment strategist at Pramerica Fixed Income: “Managers are grasping for a handle on what is likely to happen next but there has been no exact analogue.”
As long as authorities ‘rig’ markets to keep bond levels low, sovereign bonds and risk assets will dance a close tango.
“The market has lost its normal cyclicality with economic growth,” says Shahid Ikram, CIO at Aviva Investors. “Consumer demand has been flat-lining since 2006-07. Before then, it used to have a reasonably high correlation with the S&P500. Also, anticipations of greater pricing power coming through in break-even inflation rates used to have a positive impact on where earnings were going and, therefore, where the S&P traded. Again, since 2008-09 we have lost that correlation.”
Instead, a very strong new correlation has emerged between all financial assets and central bank balance sheets; liquidity has become the number-one driver of markets. That is not surprising, given the very limited impact that this massive balance sheet expansion has had on the velocity of money through the real economy. Instead, that liquidity has flooded to fund managers and bank trading desks, and given short rates at zero and eerily-low volatility, that liquidity has been put to work in carry and yield-spread trades to generate a lot of up-front return from capital appreciation.
“So it is not surprising that just a whisper of a suggestion that we are going to reduce this year-on-year increase on central bank balance sheets has this impact on underlying yields,” says Ikram.
So, has the market overshot with its recent push against this regime?
Susan Buckley, managing director at QIC Global Fixed Interest, believes we are at a fundamental turning point away from the old regime of falling rates and low volatility. “As the US Federal Reserve begins to turn off the liquidity tap, a new regime of rising interest rates and rising market volatility is in the ascendency,” she argues.
What is clear is that there are some fundamental problems in the global economy that still have not been resolved. Ikram points out that global aggregate debt levels remain at their 2007 peak. “Global growth will be challenged, as there are huge headwinds arising from the debt burdens,” he reasons.
The Fed ran into difficulty at the beginning of May, putting out what many took to be dovish signals and then getting hit by strong employment figures just a couple of days later. In response, it fine-tuned the message: the Fed funds rate would be kept low but bond purchases would begin to slow.
“Prior to this cycle, just having interest rates at zero with forward guidance would be, by far, the easiest policy the Fed has ever carried out,” says Tipp. “But we are in the fourth year of recovery, so having rates at zero with forward guidance and buying $1trn of US government bonds annually is just no longer appropriate.”
Fed Chairman Ben Bernanke’s press conference on 19 June acted as the catalyst for the sharp moves higher in yields that we have seen over summer. Bernanke was clearly positioning the Fed for a turn in the economy, but while some fundamentals are pointing to a recovery, an unemployment rate close to 7.5% and annual core inflation below 2% are indications that there is still slack in the US economy.
So, while he questions the efficacy of the Fed’s ‘QE Infinity’, Tipp still maintains that any quantitative analysis of the level and steep slope of today’s yield curve would suggest that bonds are pricing-in an unreasonably optimistic economic scenario.
“That is not to say that we may not get a stronger economic scenario, but the base case priced into the market at the moment in our opinion is too aggressive,” he clarifies.
“Ten-year US Treasury yields are forecast to clear well over 4%. That strikes us as unlikely, given the pile of private and public sector debt we and other countries are in.”
Like Ikram, Tipp argues that there is still a deflationary backdrop of very high leverage, excess capacity and little sign of any upward price or wage spiral. “From a fundamental perspective, I think the mini-stampede of investors out of fixed income is overshooting, but it is hard to predict where the sell-off is going to stop,” he says.
“This [economic weakness] would argue against this being the start of the great bond sell-off and we would expect some consolidation around current yield levels unless growth accelerates sharply,” agrees John Taylor, portfolio manager, fixed income, at AllianceBernstein.
Highly-indebted developed market economies will struggle to grow quickly enough to achieve ‘escape velocity’, raising the longer-term question about whether they can fund today’s debt as borrowing costs rise.
“My answer to that is a strong ‘no’,” says Ikram. “If you doubled yields to get back to some historical normalised levels, then the debt we have would cripple us. So expect policy to be extremely bond positive and to remain bond positive. There will be short sharp shocks, but it is in every central bank’s policy perspective to have artificially low interest rates. Our own work makes it particularly clear that if you basically stopped QE, 10-year US Treasury bond yields will drift back to 3.8-4%. If the Fed had continued with unchanged QE, yields would be around 1.7%. Tapering has increased yields to around 2.75%, the Fed has unwound half the benefits of QE and yields have drifted up in a manageable way.”
For Europe, Ikram observes that if core yields drift higher and push Italian and Spanish yields up with them, that would create the same pressure point we have seen periodically over the past three years, with the ECB stepping in to provide more liquidity. How sustainable is this situation? Ikram notes that the ECB is creating capital that is not growth-generative, has no multiplier effect, and must, therefore, at some stage, be destroyed, threatening a debt-deflation scenario – but that is a problem for the day after tomorrow.
Set and forget
If the working assumption is for low government bond yields to persist for some time, where does that leave investors? Many, such as pension funds and insurance companies, face financial repression – they have no alternative but to buy bonds, as they cannot buy equities for the growth premium because of their poor shorter-term asset-liability match. At the margins they can ratchet into credit, particularly if they implement buy-and-hold positions tactically.
“We know, from time to time, we will get blow-ups in various asset classes and then we will use those opportunities to allocate more – to higher yield for example,” says Ikram. But he adds that liquidity is so tight and bid-offer spreads so wide that these really have to be held to maturity – and in any case, duration is shorter here, leaving the fundamental asset-liability mismatch problem unsolved.
Instead, the focus is on lengthening duration in government portfolios and managing the downside risk. “Volatility levels are low, so insurance is quite cheap, so we have a barbell strategy, going for higher coupons for yield but then using some of the coupon to hedge the portfolio, taking in risk premiums and buying cheap insurance,” he explains.
Taylor describes a similar approach. “Given higher yields and a steepening of the yield curve, it is now more expensive for investors to be positioned with a shorter duration than their benchmark, in terms of the carry and roll-down which would be forgone,” he says. “As such, using out-of-the-money options to protect against a significant move higher in yields may be a more cost effective way to hedge the risk.”
QIC’s Buckley, who is more persuaded that “the yield cycle has troughed, the liquidity injections from central banks are beginning to diminish and yields just may start to return to normal levels”, an absolute-return approach to fixed income that limits exposure to the classic drivers of bond risk – rates, credit and inflation – is the only solution. The days of easy returns from surfing fixed-income benchmarks are gone, she says. “The investment environment is changing and the set-and-forget benchmark-driven strategies that provided seemingly effortless capital gains in the past will be inadequate in the era of higher volatility and rising rates,” she warns.
Finding fund managers who are able to operate in a risk-controlled manner with absolute return benchmarks may be the real challenge for investors. At some point, it seems clear that everyone will have to bite that bullet. But we may not be at that point yet, and particularly for institutions discounting their liabilities with long-dated rates, there is still an argument for retaining a healthy realism about global growth prospects, not fighting against central bank liquidity, and living off the carry from prematurely-steep yield curves.