Fixed Income  

Don’t listen to the doom-mongers

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Investing in Strategic Bonds

Don’t listen to the doom-mongers

The reversal in the fortunes of the bond market has been long predicted, yet government bond prices have kept rising and yields falling – into negative territory in many cases. Words such as ‘unprecedented’ and ‘exceptional’ has become commonplace (albeit justified). As a result, investors have been forced to cast their nets wider into perhaps less familiar corners of the market in the hunt for yield.

This is where the importance of strategic bond investors, who have the flexibility and experience to invest in all parts of the market, comes to the fore.

Demand for bonds isn’t going to disappear. The fact that some yields have turned negative doesn’t mean they can’t fall even further. The enthusiasm of central banks remains unabated, as part of the various versions of quantitative easing being pursued, especially in Europe and Japan. Elsewhere, other ‘forced’ buyers include banks, insurance companies and pension funds, which have to adhere to solvency rules that compel them to buy assets of a certain quality.

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So, where should investors look to make gains? Above all, the ability to act nimbly and to quickly shift portfolio positioning will remain crucial in the years ahead. Removing home-bias tendencies is imperative, too. The ability to alter geography and credit quality can, if implemented effectively, offset the negative factors affecting bond markets. Strategic bond funds with the ability to use derivatives can switch asset allocation quickly without making wholesale changes to the portfolio – a useful tool, but one that does not remove the problems of illiquidity, about which one must be wary.

Geopolitical concerns – the Chinese slowdown, the travails of peripheral Europe, the collapse in commodity prices – have weighed on sentiment for many months, and have acted as a major contributor to the flight-to-safety trend, benefiting core government bonds while acting as a drag on riskier investments.

However, in addition, inflation expectations have continued to fall – to a level and at a rate few had predicted. This has given a more fundamental underpinning to extraordinarily low yields.

More recently, concerns have focused on European banking. Deutsche Bank and Credit Suisse earnings for the fourth quarter were weak, leading to a more generalised malaise within the financial sector. Deutsche Bank is a particular concern as it struggles to adapt its business model to the new regulatory environment. In an echo of the 2007-08 crisis, some commentators even began to question Deutsche’s liquidity position. The bank moved quickly to refute this, issuing a statement confirming its commitment and ability to pay coupons.

It is interesting that almost nine years after the crisis began, and given the plethora of regulatory and capital changes the sector has seen, there was still perceived to be an existential threat to one of Europe’s largest financial institutions. The worry passed, but it is an episode that will no doubt concentrate regulators’ and legislators’ minds.

And so, these kinds of movements have become the new normal for bond markets. When things are bad, investors fear the worst. When things are good, they hope for even more positives. Bearish commentators are everywhere when markets are falling, with more ‘evidence’ that the world is about to end. This is leading to exaggerated volatility. But such conditions provide a plethora of opportunities.