September 2015

FIXED INCOME: Shaking out bond markets

Rubbish signThe Fed is looking to raise interest rates at last – but the bond market is keen to avoid a repeat of 1994, when multiple hikes nearly decimated it. David Stevenson asks just how prepared the industry is. The US introduced its unprecedented move to zero interest rates as a temporary measure in the wake of the global financial crisis in 2008. Seven years later, after waves of quantitative easing and the acceptance of rock-bottom rates almost as normal, the US Federal Reserve is finally ready to raise borrowing costs as it starts its ‘normalisation’ policy.  The consensus expectation is that the policy-making Federal Open Market Committee (FOMC) will move slowly because of persistent economic jitters. But the looming rate hike most analysts predict as imminent is already casting a long shadow over edgy bond and equity markets, fearful of another taper tantrum. Bond fund managers with longer memories still look back, too, with a shiver to the multiple rate hikes of the Fed’s 1994 policy-tightening cycle.  Circumstances now – not least the continuing low-inflation climate – are markedly different, but the recollection of past rate-tightening traumas is enough to keep fund managers praying that the Fed’s rate-setters will stick to the slow-and-steady script. Still, there are plenty in the market who are more than content for the Fed to act soon, fretting that a marathon seven-year run of loose money must inevitably stoke inflation sooner or later – with equally inevitable fall-out for fixed income funds. “What people don’t want is the Fed behind the curve – inflation comes through, then they [the Fed] have to raise higher, quicker and more rapidly,” says Andrew Lake, head of fixed income at Mirabaud Asset Management.  The Fed appears to have learned from 1994’s tightening cycle – a disaster for bond investors, as yields shot up amid a mass sell-off. There was no repeat during its last rate-hike cycle from 2004, when the FOMC pursued a more subtle strategy. This period saw small, incremental increases of around 25 basis points (bps) over an extended period of many months, ultimately bringing the rate from 1% to 5% by 2006. No one is expecting the Fed’s chairwoman, Janet Yellen, to raise rates to anything like the 2006 peak in this cycle, and she has stressed on many occasions that the FOMC’s decisions will be data-dependent. “It’s not a compelling story that the US needs to start rising rates. We’re at the same place we were two-and-half years ago, growth is at 2% to 2.5%, inflation is somewhere close to zero,” says Graham McDevitt, global strategist, Macquarie Investment Managers. If the Fed raises rates by 25 bps, the impact on the bond market ought to be negligible. There would likely be some upturn at the front end of the yield curve for US Treasuries with shorter maturities, but also probably a flattening out for those of longer duration, says McDevitt. Yet while a market earthquake when the Fed moves may be a low risk, the expectation remains that tremors may occur. Alan Wilde, head of fixed income at Barings Asset Management, says: “Any damage will not be the result of a surprise, but more that investors across the spectrum [including in government bond and corporate credit markets] have not fully judged the consequences of tighter monetary policy.” There may well be more volatility – something active fund managers and hedge funds purport to thrive on. At the same time, there will be more risks around too, though bond fund managers have ways of mitigating this. DURATION HEDGE
Duration risk is basically the threat posed by interest rates to fixed income products, but there is an industry-wide way of hedging this out.  Using futures is a common method of hedging out duration risk. Lake, at Mirabaud Asset Management, uses futures as a hedge because they are liquid. His firm is more concerned with capital protection and aims to “limit the downside risk when there’s a big sell-off”. It was a fear of duration risk that caused the bund sell-off earlier this year as inflation figures were better than expected. As fears of deflation withered, so did the desire to hold sovereign bonds at super-low yields.  Another method that duration avoiders like to employ is using floating-rate products. “The idea of having good-quality credit without duration is very attractive rate now, which is why clients are asking about asset-backed securities as they’re all floating rate notes,” says April LaRusse, fixed income product specialist at Insight Investment. These products are not to everyone’s taste, though. Lake can see no reason why an investor would prefer a floating-rate product to investing in loans, which also do not have a fixed rate. Floating-rate bonds have a very short call period, he points out. This is great if you’re concerned about interest rates for the year, but the issuer can just recall the bond and reset the coupon.  LaRusse, on the other hand, argues that loans are a riskier investment, and McDevitt notes that the asset class does not have a great deal of liquidity – a problem in the fixed income space, especially for corporate bonds. If duration is one of the main concerns for bond investors, then credit risk – the fear of a company defaulting – seems to be a lesser worry at the moment, despite expectations of higher interest payments for businesses as rates begin to rise. This is curious, as a large part of the US high-yield corporate bond market – between 12% and 17% of the market, according to estimates – is made up of energy companies.   As commodity prices have collapsed, and with the oil price halving in the space of a year, the pressure on some of the highly leveraged energy companies is intense. Yet the yields available in the sector, reaching around 9%, are tempting to many investors.  “Energy defaults will certainly occur,” says Evan Moskovit, head of global investment credit at NN Investment Partners, though he adds that these are expected to be limited to higher-cost producers and those that provide related services.  JP Morgan estimates that the high-yield energy sector may experience a default rate as high as 10% in 2016, while the overall US high-yield default rate is predicted by the bank to remain low, at around 3%. Yet despite the heightened credit risk apparent for high-yield energy companies, the sector is still attractive to some fund managers.  “We think there are opportunities in the best-in-class [parts of the US high-yield energy sector],” says Richard Ford, European head of credit for Morgan Stanley Investment Management.  Such opportunities could arise if, for example, investment-grade energy companies start acquiring high-yield companies, which would be positive for bondholders. When looking for a place to park money during a rate hike, history has shown that high yield can be a good choice. JP Morgan research shows that in the 15 years that Treasury yields have increased since 1980, high-yield bonds have posted an average return of almost 14%. This compares to an average return of 4.5% for investment-grade bonds over the same period. DON’T FORGET THE UK
It would be remiss to discuss rate hikes without mentioning that the Bank of England (BoE) is also forecast to raise UK interest rates soon. At July’s meeting of its Monetary Policy Committee, a rate hike was ruled out by  eight votes to one, but all the signals are that an initial increase remains in prospect by next year.  However, as Ford at Morgan Stanley Investment Management observes, the UK is more sensitive and exposed to external factors. These may include macroeconomic events such as China’s shock 2% devaluation of its currency last month, coupled with other key economies such as the Eurozone and China continuing to loosen rather than tighten monetary policy. The UK will be keeping a close eye on the Fed.  The UK is sometimes seen as the middle ground between the US and Europe and with Bank of America Merrill Lynch indices showing that sterling-denominated high-yield bonds returned 4.88% year-to-date compared to just 2.99% for Eurozone high yield, this does appear to be the case. According to Lake, BB-rated companies yield around 3.5% in Europe but 5.5% in the US. Not only is that a big difference in absolute yield terms, but the spread is also better. B-rated companies can yield up to 7% in the US; in Europe, it’s nearer 5.5%. “You can argue that Europe’s interest rates aren’t going anywhere for some time so maybe [that means] a more bond-friendly environment,” he adds. In the low-yielding European bond market, investors may be making errors. David Lloyd, head of institutional fixed income portfolio management at M&G Investments, says: “People are doing it the other way around, [saying], ‘I need a yield of X, how much risk do I have to take to get it?’ In an environment where yields are low, I think there is a heightened chance of a misallocation of capital.” Will a Fed rate hike stop this misallocation? If it brings better returns for decent credit and maybe triggers a few defaults among weaker companies, it may well entice investors back into the bond markets. ©2015 funds europe

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