Multi-managerJun 16 2014

Fund Selector: Which bonds to choose?

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The last time I wrote an article in this section, its theme was about the ongoing economic recovery in the US and the response in financial markets.

The first quarter US GDP number was actually disappointing, but this was believed to have been as a result of weather and as Q2 began the data has picked up nicely.

All of this has allowed the S&P 500 index to make new all-time highs, so clearly equity investors are behaving in a pretty bullish fashion. The oddity about this is that the bond market has also been behaving in a bullish fashion; rallying to achieve lower yields not seen since June last year.

Typically this would be viewed as the bond market suggesting that the economic recovery could be faltering, which would be contrary to the message from equities. So what is going on?

This was meant to be the year that equities were going to be able to make good progress with the tailwind of good growth, good sentiment and lack of a significant headwind (not even Ukraine has caused a misstep). So far so good.

This was also meant to be the year that would see central banks begin to remove some of their accommodative policies, with the US Federal Reserve beginning the taper of quantitative easing, which should lead to government bond yields gently rising as the most significant buyer steps back. This is the bit the consensus seems to have got wrong so far; the policy taper is happening but yields have fallen, not risen. Why?

The Schroder multi-manager team suspects there may be quite a few elements that are driving these factors. One of the benefits of the economic recovery in the US has been the increased collection of taxes, reducing the budget deficit, so the government needs to borrow less money and thus the issuance of government bonds should decline.

As something becomes rare the price tends to rise (in the case of bonds this means yields fall). Investors may expect this phenomenon to continue and are therefore likely to persist in their purchases even as their prices rise. Natural buyers of these bonds would include pension funds and insurance companies, both of whom may be looking to reduce successful equity investments to switch into lower credit risk securities, such as governments bonds.

While the US economy appears to be in good health, other areas of the world are still struggling. Europe appears to be struggling with deflation, which has caused European government bonds to decline (low/no inflation makes these securities look attractive even at low yields).

This decline in global bond yields may influence other bond markets, such as the US and UK, as the equilibrium level of yield is moved lower, making their relatively higher yields more attractive.

We suspect the most compelling reason that government bonds have done well this year is that the consensus opinion was very strong that this could not happen.

It is often the case that when a belief is held by many, the opposite will happen. In this case it is our contention that a lot of investors were ‘short’ government bonds, so a small rally forced the shorts to reduce (achieved by buying bonds) which caused a bigger rally, which forced more investors to cover their shorts etc, etc.

Our conclusion is that government bonds have become more expensive and therefore dangerous to future returns.

Marcus Brookes is co-head of multi-manager at Schroders