While government bond yields and, in particular, gilt, bund and treasury yields have all been rising in recent weeks (German 10 year yields doubled last week) the last few days have seen sudden, sharp moves that have seen investors lose significant amounts of capital.
As one investor put it to Portfolio Adviser on Thursday, if you invested in 30 year German bunds in April, you have seen your capital slashed by around 30%. Indeed, 10-year bund yields, which fell as low as 0.06% in April, currently trade at 0.64%, more than a 10 fold increase, while in the UK the last time 10 year gilt yields were around 2% was in November last year.
Laith Khalaf, Senior Analyst at Hargreaves Lansdown points out that the recent falls should be seen as a warning shot to bond investors.
“The sell-off is a reminder of the risk of investing in bonds at such low yields,” he said, pointing out that at 1.98%, the yield on the benchmark 10-year UK gilt is almost 50% higher than where it was at the end of January, and those investors that bought in then have seen one and a half years’ worth of income wiped off their capital values.
So what has changed?
The first factor is the oil price and its impact on inflation expectations. At the start of the year, many investors expected oil prices to fall even further than they had already, thus prolonging the disinflationary effects that cheaper energy has on the world. Recently, however, prices have begun to rise and many now are more concerned once again with inflation.
As TwentyFour Asset Management pointed out in a note on Thursday, while it expected the fall in energy prices to begin working it was out of the inflation data by the Summer, conditions at the beginning of the year were very supportive of the extremely low interest rates.
“In the US it is no longer about rates rising ‘sometime in the distant future’ and when ‘normalisation will begin’ but ‘in which month’ this will happen. The recent weakness in US economic data has merely pushed back expectations from a June lift-off to a September one; both of which are just around the corner in economic terms.”
The other factor, which pertains more to Europe is that growth in the region has surprised on the upside. This has meant that participants are beginning to feel more positive about the outlook for the region.
And, as TwentyFour notes: “30-Year Bund yields in Germany that are less than 50% of the ECB’s target inflation rate, do not make fundamental sense when the Central Bank is willing and able to deploy extraordinary policies to achieve that inflation. The market has now woken up to this.”
Both of these factors, do not however, explain the suddenness of the moves seen over the course of the past few days.
Jonathan Gregory, head of UK fixed income at UBS points out that sell offs in bond markets in the immediate aftermath of quantitative easing are not unprecedented and, in fact were visible in both Japan and the US when those QE programmes started, but he said there are also a number of technical factors that could be behind the moves.
The first is one of positioning. “Most of the market was facing the same direction, everyone was long Europe. And, of course, there have been a number of investors that have been shifted down the risk spectrum. So, there is definitely an element of a bit of a wash out in the consensus trade,” he said.
The other factor to note is that there has been something of a volatility shock, with a number of participants taking on large positions on the back of very low volatility, only for volatility to rise.
“A number of people that had scaled positions on the back of low volatility were stopped out when volatility rose, which would have pushed prices down and had something of a snowball effect.”
What is next?
Because bond yields remain exceptionally low, even after the increases seen in recent weeks, which means the markets remain exceptionally sensitive to interest rate risk. Last Friday’s strong non-farm payrolls data from the US only seem to make a Fed rate hike more likely.
“We think the evidence argues for an initial policy rate lift-off by the Fed in September, as the central bank has a window of opportunity to move, with stable markets, longer-term payrolls growth at very high levels, and foreign central banks taking the reins of policy accommodation,” says Rick Rieder, chief investment officer fixed income at BlackRock.
Chris Iggo, in a note out last week, said that there could well be some “nasty times” ahead for fixed income investors.
“If there are and we see a disorderly re-pricing across the whole asset class, liquidity will be a major issue… We know that bonds are expensive and that many investors won’t need a great deal of encouragement to start redeeming their bond holdings.”
But, he said, while the price action is likely to be out of line with fundamentals, the credit fundamentals are nowhere near as poor as they were in 2008 and, there are likely to be investment opportunities to reinvest when prices fall.
“It’s difficult to prepare for but, just like for the argument to reduce interest rate exposure, holding higher cash balances is probably a wise thing to do today. After all, the opportunity cost of holding cash rather than bonds is very low (although not quite as low as a week or so ago).”