Meet the contrarian bond market bulls as summer volatility beckons

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Some credit managers are predicting a market rally, at least in the short term, as the recent market sell-off restores value in the bond markets.

Blood is on the dance floor for fear-soaked unhedged bond investors, faced with paper losses amid the global bond sell-off. As some analysts pronounce the death of the astonishing fixed-income era, in favour of equities, some credit managers reckon pockets of fixed-income value have emerged in the short term as a correction is on the cards. “Asset allocations should swing back from risk assets towards bonds somewhat because yields are higher and growth prospects are not as rosy as previously expected,” predicts Graham Neilson, chief investment strategist at Cairn Capital. “There is likely to be a counter rally before things get difficult again.” The markets moved far and fast after Fed governor Ben Bernanke’s recent comments regarding an eventual end to quantitative easing (QE), partly because of the length of time yields had been disconnected from risk assets and nominal growth, says Neilson. Since the start of the year, yields have been 1% to 1.5% too low, meaning the risk of a sharp rise was high, says Neilson. Starting in April, the newly aggressive stance of the Bank of Japan has added to that build-up of pressure: its balance sheet expansion to GDP ratio being around twice that of the Fed’s, says Neilson. This has arguably put additional pressure on the back-end of the yield curve and maintained the bond versus equity dislocation – though fund flow data suggests Japanese investors have sunk their cash into domestic equities rather than the long-hoped-for bid for European and emerging market (EM) fixed income markets. The recent global bond market sell-off is “a clear indicator of an improvement in short-term risk”, according to CheckRisk, a consultancy that models risk to help its institutional investor clients make asset allocation decisions. “The size of a correction is sometimes proportionate to the time a mispricing has lasted, and how long pressure has been building up,” says Neilson. He traces the start of the equity bull run to 2011, the lowest point of the euro crisis, since which point the S&P had rallied by around 75%, until recent falls. In that same almost two-year period, US 10-year bond yields have gone nowhere. While the recent correction probably does not signal a return to the highs of May 2013, “markets have become oversold and a reversion to mean now appears increasingly likely”, CheckRisk says in a weekly circular to clients. But it warns of a volatile summer – at least until September. Once markets realize the Fed is not likely to materially unwind its QE policy and hike rates for years, “we expect to see a return to bull markets, all other things being equal”, says CheckRisk. The stakes are high. “We have yet to see the fundamental impact of recent higher yields, lower equities and EM disruption,” says Neilson. “If market yields rise and stay high then growth and debt serviceability fall, and overall growth prospects decrease.” Louis Gargour, chief investment officer at LNG Capital, adds: “I would minimize duration and maximize credit and equity exposure.” LNG’s portfolio has an average duration of less than two years and is net 50% long, with short positions in rates sensitive credits, particularly long-dated investment-grade names. “High yield offers the best fixed income opportunities right now,” says Gargour. “You can get a spread of 500 to 700 basis points over treasuries and that is all credit, not rates.” By contrast, he says, investment-grade bonds pay a meagre spread over treasuries, but without the same level of protection. Whether investors want to pile into high-yield or not, its prospects look improved, with yields higher and spreads wider than a month ago, after its recent shake out, says Neilson. However, he disagrees about duration. “We don’t typically take first-order duration risk but generally longer duration just got more attractive,” he says. “There tends to be false comfort in the phrase ‘short duration’, and therefore being insulated against the worst of yields rising. An investor can be short duration by being long the belly of the curve in five- and 10-year bonds, and short 30-years relative to the benchmark. “That doesn’t insulate against yields rising when yields rise across the board, particularly at the belly.” Ten-year treasuries went from 2.1% to 2.6% – a change of 50bp – in a week. “If the Fed reduces the money supply, the next stopping point for yields will be 3%,” says Gargour. “There is a lot of bad news ahead for the government bond market.” However, the outlook is much bleaker for EMs, which Neilson says “still look poor, even with equity markets having corrected by nearly 25%, compared to around 10%, on average, for developed markets”. This is partly down to dollar weakness. Many EMs rely on exports, particularly of commodities, that are priced in dollars, meaning as that currency weakens, their trade balances deteriorate. EM bond funds have been hammered by the recent sell-off and will be looking at large mark-to-market losses, which might well force them to reduce their positions further in coming weeks, predicts Neilson. That will tend to keep those markets somewhat depressed. This, along with the German election in September, makes for another difficult summer for Italy and the other usual peripheral suspects, Neilson concludes.

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