However, despite QE now at an end in the US, unemployment down and economic growth looking fairly reasonable, the yield on 10-year US Treasuries has compressed even further over the course of the year than people thought it could, while yields on gilts and European sovereign bonds have done something similar.
Bond investing upside down
As Bill Eigen, head of JP Morgan Asset Management’s absolute return and opportunistic fixed income team said recently: “The Federal Reserve and central banks have broken the fixed income markets, they don’t react to the things they are supposed to.”
He added: “US rates now react to things Mario Draghi says, as opposed to economic realities on the ground in the States, because there is a view out there that has never held in history, that all developed market rates need to converge to the lowest developed market rate out there.”
As a result of this, Eigen says, investors have needed to disregard everything they have learned about fixed income in order to make money this year.
“The only thing that has worked this year, is looking at German 10 year yields and assuming that all other developed market yields are going to converge to it. Is that a high probability strategy? No, but it is working for now. But, things like that work until they don’t and it is not a strategy that engenders confidence.”
Head of Schroders multi-manager team Marcus Brooks agrees with Eigen that the market is concerning and has made the call to put almost 37% (almost 40% on a look-through basis) of the Schroder MM Diversity Balanced Fund portfolio into cash. And, while Brooks admits that he, like many others, was wrong on the call in 2014, he does not believe that yields can compress much further.
And, he said: “Once these things start losing you money, people are going to be scratching their head, because after a 30 year bull market, people do not expect to lose money on bonds.”
“This is going to be a bit of a shock to people because it is the ‘safe’ part of their portfolio. In equities you know that the profits are fairly cyclical, alternatives can vary over time, but people are of the view that you don’t lose money in bonds. You don’t expect the safe part of your portfolio to be able to suffer a 20% capital decline.”
A glimse of hope in high yield
However, there are signs that other, higher-risk parts of the bond market could offer attractive opportunities.
Tom Beckett, CIO at Psigma said in a note out on Monday, in the short term, “this is the most depressed I have felt about our fixed interest positions since 2011, when government bond yields collapsed and corporate spreads widened.
But, he added: “As I look forward, this is the most optimistic I have been since those low days. Spreads (excess yield) over Treasuries on US High Yield have expanded over the year and offer decent medium term value in our view. Having been expensive when yields fell below 5%, US High Yield credit is fair value back above 6%, especially given that spreads have gapped by a further 80bps this year.”
He said that while the group was bearish on US high yield bonds earlier in the year, since October, much of the hot money has moved out and, over the next three years, the asset class could produce returns in excess of US equities. “There are arguably ‘once in a cycle’ opportunities to exploit in the lower echelons of the credit universe, where investors have sold out heavily on the back of concerns about illiquidity.”
While anything of high-quality with a yield has been bid up, lower rated bonds have been shunned, he said, arguing: “if you can find the right manager to buy the right bonds, there should be a sensational buying opportunity on offer, unless you are a fully signed up member of the Economic Ice Age/ Financial Armageddon club.”