Global contrasts: Where are bond managers buying?

On May 22, Federal Reserve chairman Ben Bernanke hinted to congress that America could reduce its bond buying if economic data improved, causing a sharp drop in pricing and a commensurate rise in yields.

Within days, yields had risen again on renewed market volatility - and in Mid-June, disappointed markets fell further when the Bank of Japan decided not to increase its monetary stimulus package.

Pricing uncertainty

But Jason Hollands, managing director of research firm Bestinvest, believes this renewed rise in yield may not necessarily be beneficial for fixed income investors hoping for renewed value.

“The extraordinary measures being implemented by central banks have led to clear distortions in capital allocation across asset classes, but none more so than fixed income where aggressive bond buying has hiked prices and shrunk yields,” he says.

“While this may continue for some time yet we are firmly of the view that risks are growing in fixed income and note there are now clear signs of increased stress in the bond markets. Once the market starts to rapidly factor in an end to QE, the effect could be quite brutal.”

Robin Marshall, co-manager of the Smith and Williamson government bond fund, says the problem for bond investors is that no one can judge how much the market is being artificially propped up until monetary easing is taken away.

“Bernanke always said the exit to QE would be straightforward, but we have learnt from the last month that it won’t be. The more bonds they buy, the more difficult it will become. We don’t know which assets are priced to QE and which to fundamentals,” he says.

But the manager believes that investors who keep a clear head through the turbulence can take advantage of the cheaper bonds on offer.

Mr Marshall has capitalised subdued inflation environment by purchasing more US TIPS [treasury inflation protected securities], which have lost around 7 points now that inflation protection is less prominent in investors’ minds.

He also thinks that treasuries and gilts could see a resurgence from investors seeking a safe place to shelter from market volatility, while an area of concern is eurozone government bonds, as he feels that yields have come down without a change to the underlying macroeconomic picture.

“The ones that look vulnerable now are in the eurozone periphery where yields have converged without the ECB [European Central Bank] having to do anything with OMT [outright monetary transactions],” he says.

“The yields have come down but the fundamental issues of the crisis have not been resolved.

“Peripheral markets don’t look good value in the context of risk return. Lots of the competitiveness, banking and fiscal union issues haven’t been resolved and won’t be until after the German elections in September.”

Beyond government debt

Iain Stealy, co-manager of the JPMorgan £638.5m JPMorgan Strategic Bond fund, says that the price drop in the “safe havens” is overdone and government bonds still do not look attractive

“There has been a lot of talk of Quantitative easing ending and that spooked bond yields, causing them to rise. Papering does not equal tightening, it means slightly less QE going in the system. We are not expecting a spike up at the moment,” he sys.

Unlike Mr Marshall, the JPMorgan manager is still not finding any global government’s debt appealing, as the believes it cannot compete with inflation. Instead, he is investing in US high yield bonds as he believes the country is “leading the way” in the global economic recovery with growth rates of 2 per cent.

“We are not seeing value in core government bonds given five and 10-year treasuries are at 1.1 and 2.2 per cent, which is not attractive on a relative basis when compared to inflation. We are avoiding government debt and going for high yield and investment grade corporate bonds,” he says.

David Zahn, who co-manages the Franklin Templeton Strategic Bond Fund and is head of European fixed income, agreed that core government bonds do not offer enough to compensate for their sluggish yields.

“If you look at gilts and treasuries, they don’t offer a lot of value compared with the debt dynamics,” the manager said, adding that unlike some of its peers, the Strategic Fund doesn’t hold any gilts at all.

In contrast to Mr Marshall, the manager sees some glimmers of opportunity within the eurozone in the form of Italy.

“One of the countries we think is doing well is Italy. It is doing the right things and I think there is still scope there for performance, despite wobbles. Italy looks like it’s going to be in surplus, and although they have a high debt-to GDP [ratio] their rates have come down,” the manager said at a conference last week.

“They are now able to issue debt at sub 5 per cent, and that’s pretty good compared to where they were able to issue in the past. That’s positive for Italy, and for Europe.”

Mr Zahn also believes emerging market government bonds offer attractive opportunities because the fundamentals are better than in other nations.

“Developed markets’ debt to GDP levels has been going up, while in emerging markets they are going down. They don’t run budget deficits as well as having good growth dynamics,” he says.

The manager has emerging market bonds in countries including Brazil and Portugal and adds that being able to use local currency gives an additional yield.

While the managers were divided over which regions were the best to find yield, they agreed that it was tougher to find the level of yield they were seeing five years ago and view diversification as a key way to maximise returns.

While government bond yields have reached historic lows, the recent uncertainty over quantitative easing could give investors a chance to capitalise on price weakness ahead of a potential increase of money printing, which could be triggered by the arrival of new Bank of England governor Mark Carney this summer, or by weak economic data globally.