What last month’s shake-up means for bond markets

This autumn has been a turbulent time for bond markets, but in the aftermath of recent volatility opportunities have emerged.

Short duration positions are likely to remain the preferred bias for the Insight fixed-income team given the recent volatility in markets, as the desk focuses on short-term risk management.

The team is currently short duration in the US, Japan, the UK and core eurozone.

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On the US, fund manager Isobel Lee says: “It appears that investors still have the cash to invest and prefer to own the short end of the yield curve rather than putting it on deposit. The sharp drop in US Treasury yields in October seems to reflect low levels of liquidity and investor positioning rather than a significant change to the US economic outlook. We still expect the US Federal Open Market Committee to start raising rates at some point in 2015.”

The Insight team is predicting that if the current economic pace of improvement in the US continues, then economic conditions will prompt the first change in interest rates in more than six years in early summer 2015. Thereafter, it expects a steady increase in rates reaching a peak of 3.5 per cent at the end of 2017 — below the peak of the last cycle.

Meanwhile, in the UK, for the first time in half a decade the team is including a rate change in its 12-month view.

Andrew Wickham, head of UK and global fixed income, says: “We remain marginally negative on the UK. Although we still believe interest rates will start to rise in 2015, lower inflation figures and recent rhetoric from the Bank of England have pushed out our expectations to at least beyond the general election in May. We expect rates to peak below the levels of previous cycles at 2.5 per cent.”

Wickham stresses that to some extent this forecast is simply the weighted average of several possible outcomes and much depends on the path of growth and forward-looking indicators over the next 12 months.

Turning to Europe, interest rates are expected to stay low as the economy gradually recovers, but with German Bund yields having fallen to historic lows the team believes the likelihood of yields rising is higher than the probability of further falls.

Gareth Colesmith, European fixed-income fund manager, says: “We have significantly reduced our exposure to the ‘periphery’ in recent times, taking profits.”

In terms of the corporate bond part of the fixed-income market, the team thinks the current environment continues to be supportive, with balance sheets generally strong and low default rates, which will probably continue given funding costs are likely to remain manageable.

The team says there is still value in US dollar and sterling investment-grade credit, particularly within the financial sector, while secured loans are also attractive.

Regarding asset-backed securities (ABSs), valuations have become more expensive in recent times, especially after the announcement of the European Central Bank’s (ECB’s) asset purchase programme. The team remains positive on the outlook for ABSs but has taken profits in certain areas of the market in the last few months. They believe peripheral eurozone ABSs are likely to continue to benefit from the ECB’s plans.

Back in September, the team thought high-yield valuations looked slightly stretched, but after the recent sell-off, the asset class could potentially produce some interesting opportunities. High-yield fund manager Uli Gerhard says he is waiting for the dust to settle.

Another area that could produce some compelling opportunities once volatility subsides is emerging market debt.

Colm McDonagh, head of emerging market debt, explains: “Emerging markets have largely been driven by external forces. We are therefore taking a cautious stance given the significant rise in volatility and the increase in correlations between asset classes.

“We remain comfortable holding local bonds given the improving domestic inflation environment, but have cut our currency position to a net short.”

He notes there has been an increased divergence in performance among countries reflecting the disparity in economic, political and policy outlooks.

Meanwhile, currency markets, which had started to show clear trends in September, have suffered the knock-on effects of capital market volatility and so the team has generally reduced positions as a result.

Paul Lambert, head of currency, says: “We remain long the dollar but with a smaller position since to strengthen much further from here the dollar will probably require rate expectations and bond yields to rise in the US.”

The team’s other positions include shorting the euro against the US dollar — given that the ECB’s further easing of monetary policy will be negative for the currency — and shorting the Japanese yen against the US dollar, because monetary policy has diverged and investor outflows from Japan continue.

Finally, the team holds short positions in the Australian and New Zealand dollars, reflecting weaker commodity prices and slowing Chinese demand.


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