The relentless bond rally – mid-year review and update

Kamyar Hazaveh's picture

One of the major themes that we introduced during Signature's Spring 2014 Roadshow was "lower for longer". Across the country in meetings with mutual fund advisors, institutional consultants/clients as well as individual investors, we laid out our thinking and reasons as to why a rapid disruptive rise in interest rates was unlikely and how the tame and accommodative interest rate policy was going to lend further support to the strength in risky assets including fixed income spread products and equities. In this blog post, I provide an update to our interest rate view.

Mid-year review

The "lower for longer" thesis that we laid out at the beginning of the year was based on two major pillars. First, the cumulative level of public and private debt in advanced economies as a percentage of the developed world GDP has reached levels that in order to finance the debt, interest rates have to remain low or else the advanced economies enter contractions as the cost of debt servicing eats into disposable incomes. The second reason was the global nature of the developed market rates and how despite the relative strength of the North American economies, the weakness in the European and Japanese economies will cap how high interest rates in the rest of the world can rise.

Both arguments have proved to be right in 2014. Higher interest rates at the beginning of the year put a significant dent into the demand for mortgages in the U.S. as mortgage applications and refinancing activity fell to the decade lows. The Q1 real GDP in the U.S. (although affected by technicalities of some changes in GDP calculations) collapsed 2.9% which proved the fact that the weakness in the economy was real, broad-based and not all "weather-related" as the sell-side economists unanimously had advertised. Given the current tracking estimates of the U.S. Q2 real GDP, the first half economic growth in the U.S. is going to be flat to negative. It is now clear that it is impossible to realize 3% average growth for 2014 which a lot of macro forecasts and short duration trades at the beginning of 2014 were based on. (That would require 6% real growth in the second half!)

Globally, deflation and the economic weakness in Europe finally forced the European Central Bank's (ECB) hand into introducing substantial easing measures to encourage lending to the real economy leading to a substantial drop in core European rates and the peripheral government bond credit spreads. The package of monetary easing measures put the ECB at the forefront of unconventional policy. Mr. Draghi (Head of the ECB) took the best parts of unconventional policy from the rest of the world in an all-encompassing package of monetary stimulus. As a result, German bonds led the rally in fixed-income markets globally dragging the rest of the developed world rates down in perfect classical correlation. Elsewhere, Japan has been dealing with the uncertainty of the effects of the April VAT-hike on its domestic real growth and the realization that reaching 2% inflation goal set out by the Bank of Japan (BoJ) about a year ago, looks farther out of reach.

Our Canadian and Global bond funds are up around 4-5% in the first half putting them neck-in-neck in terms of performance with the best-performing asset classes globally. One of the questions that we were frequently asked during our roadshow was our opinion on short-duration funds, floating rate funds and loan funds. Our high-yield credit experts explained why they did not favor loans due to early prepay-ability. From a duration and interest rate perspective as well, these strategies made little sense to us. The truth is that duration risk was cheap at the beginning of the year. The investors who shed duration risk at the beginning of the year, missed the rally in the bond market. In our investment philosophy, there is no such thing as an inherently "bad asset" or "good asset". A "bad asset" can be a great investment at the right price. Putting one's money into dedicated floating rate funds amounts to saying that "duration risk is bad at any price". That is not true as this year's performance of our Canadian and Global Bond funds are a testament to that.

Market outlook

At the mid-point in the year and watching our interest rate view pan out in the first half, we pause and ask "where do we go from here"? To articulate our view on interest rates, I touch upon three areas to help outline our view. First, the developed world economic growth looks lackluster, unimpressive and average at best. Growth is the United States and Canada is averaging around 2% with no signs of acceleration. The escape velocity (which refers to 3-4% real growth) that the U.S. Federal Reserve (the Fed) and a slew of sell-side economists dream about, remains elusive. Economic cycles in Europe, the U.K. and Japan have topped and we expect all three regions to decelerate. The consensus was blind to the acceleration in economic cycles in all three regions last year and was "surprised" by the strength in these regions. The same phenomenon is happening today only the reverse: the consensus is blind to the coming economic cycle slowdown.

Second, the pricing of the bond market looks rich (expensive) relative to the beginning of the year. In early 2014, the market was pricing 2% real growth and 2% inflation at the long-end of the US bond market. We described that pricing as fair. Today, the real growth priced at the long-end is about 0.9% in the U.S. far below what the economy has realized in recent years (average of 2%). The pricing of long rates is more extreme in Europe where long-end rates have fallen to levels only seen at the depth of the European debt crisis in July 2012. German 10-Year Bonds have broken the record low yield reached in July 2012.

Chart 1. Pricing of real rates, nominal rates and inflation at the long-end of the U.S.

Chart 2. Putting the current nominal rate pricing in the U.S. and Europe in the context

Third, the consensus comprising of economists, strategists and most vocal market participants is more constructive on the bond market as they are licking their wounds from being so spectacularly wrong about the direction of interest rates in 2014. In my meetings with major trading desks and strategists in London and New York this month, it is obvious that the consensus has done a 180-degree change of view to a more constructive view of the bond market for the rest of the year.

It is mainly because of the extreme pricing in German bonds and the change of the consensus view on the bond market to more constructive that we think some of the long-duration and long carry and roll-down [1] positioning are vulnerable to a potential re-pricing in the bond market. There are two things that are certain to us: both the economic environment and consensus views will always go through cycles. It is impossible that "lower for longer" or "great moderation 2.0" (as some strategists call it) is the end of finance, trading and portfolio management. It is dangerous for the market as a whole to think that way and for us as bond managers looking to outperform to subscribe to this theme forever.

Pulling back from longer duration assets and positive carry positions is easier said than done. This is the most difficult part of the market cycle for a bond manager as betting against the crowd means giving up income. Timing becomes crucially important and structuring good trades to minimize negative carry and roll-down of these strategies is paramount. We employ a variety of advanced optimal strategies in our portfolio to prepare for the eventual re-pricing in the bond market. Moving the duration exposure in the portfolio away from high-beta sectors on the curve, adding protection against unexpected inflation with inflation-linked bonds, adding quasi-government spread products and raising the convexity of the portfolio are some of the strategies that have been implemented in our bond portfolios. I will expand on these strategies in future blog posts.

Conclusion

What is clear is that investing is never meant to be easy. Going into floating rate funds from bond funds is equivalent to saying "duration risk is bad at any price". We think that is the wrong approach. Duration risk can be attractive at the right price. Determining value and the strategic and tactical positioning of the portfolios is best left to professional managers with a global view of markets. What happens in Canada often does not matter for the direction of interest rates either in the broader developed market rates or even in this country itself. The truth is that our beloved home country is a small portion of the developed world economies and developed bond markets. A thorough understanding of the interest rate environment is only possible by understanding the backdrop in the U.S., Europe, Japan, the U.K. and emerging markets to be able to foresee emerging trends and latest monetary and fiscal policy thinking. At Signature, we have the global advantage and that is the bottom line.

[1]Carry refers to the income generated by holding a long position in a bond assuming that the yield of the bond remains constant from the beginning of the holding period to the end of period. Roll-down refers to the appreciation in the price of the bond as the yield of the bond drops due to the passage of time (the bond gets closer to maturity) in a steep yield curve environment.   

 

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