Bonds face up to stormy conditions: three key trends this week


Jonathan Platt, Head of Fixed Income

15 February 2018

1.      Government yields are (finally) heading higher
Global government bonds sold-off on Wednesday, with the yields on both gilts and US treasuries hitting their highest levels in over a year. The yield on five year gilts pushed to levels not seen since the beginning of 2015, while 10 year US treasuries pushed ever closer to 3%.
While the sell-off was strongest at the shorter end of the curve, with some market participants concerned that rising inflation means that the US Federal Reserve (Fed) might need to raise rates faster than previously anticipated. However, any bouts of curve flattening are unlikely to impact our longer-term view of a steady rise in gilt, bund and treasury yields, and are maintaining a moderate short duration position in our government bond portfolios to help mitigate this. 
Elsewhere, with gilts still looking relatively expensive, we’ve been selectively entering into cross market positions including Canadian bonds, which outperformed strongly during the week off the back of weaker than expected Canadian employment data.
2.     Credit markets look orderly, despite equity panic
While there has been a certain degree of nervousness in the sterling credit market in February, the fall in bond prices should be viewed against the context of a strong performance in the latter half of 2017. While trading has been a little thinner, credit spreads are still fairly tight, and there has been none of the panic which infected equity markets during last week. European corporate bond markets look particularly robust and legacy tier 1 bank debt has remained pretty steady throughout this time.
Some of the biggest moves in credit markets have been driven by other forces entirely. With twists worthy of a Scandinavian crime drama, Danish telecoms operator TDC’s bonds widen more than 100bps after it tried and failed to take over Swedish firm Modern Times Group, before itself being the subject to a bid by a trio of local pension funds working in consortium with infrastructure specialist Macquarie.
3.     Liquidity offers little comfort in high yield 
One of the most surprising outcomes of the sell-off was in the high yield market, where lower rated CCC bonds and emerging market paper were performing relatively well compared to BB rated assets. We think that both risk appetites and liquidity probably played a role here, with investment grade tourists selling off what would have been the riskier end of their portfolios. For traditional high yield managers, the tradability of these BB bonds might have made them a more natural sell as risk-averse investors withdrew money from portfolios.
In addition, short dated assets with less sensitivity to rates and inflation tended to weather the recent turbulence more effectively. Many of these shorter dated bonds also have the potential to be called up early, offering issuers a chance to lock in cheap financing before yields rise further.
 
While there has been some increased volatility in bond markets, the events of the last few weeks have demonstrated many of our convictions about the nature of fixed income investing. The premium placed on liquidity is often overstated, as events in high yield markets have proved, with more liquid bonds being disproportionately hit during the sell-off. 
Recent corporate failings at Carillion, whose various creditors look unlikely to recoup much of their capital, highlights the role that security over physical assets can play in helping to mitigate these risks. Above all else, current conditions highlight the benefits that being truly active can provide. Being able to choose to sell in light of corporate actions unfavourable to bondholders simply isn’t an option for benchmark-hugging passive investors. While quantitative easing has compressed yields indiscriminately, as this is withdrawn, investors will discover how well various assets fare without support from loose monetary policy.

1.      Government yields are (finally) heading higher

Global government bonds sold-off on Wednesday, with the yields on both gilts and US treasuries hitting their highest levels in over a year. The yield on five year gilts pushed to levels not seen since the beginning of 2015, while 10 year US treasuries pushed ever closer to 3%.While the sell-off was strongest at the shorter end of the curve, with some market participants concerned that rising inflation means that the US Federal Reserve (Fed) might need to raise rates faster than previously anticipated. However, any bouts of curve flattening are unlikely to impact our longer-term view of a steady rise in gilt, bund and treasury yields, and are maintaining a moderate short duration position in our government bond portfolios to help mitigate this. Elsewhere, with gilts still looking relatively expensive, we’ve been selectively entering into cross market positions including Canadian bonds, which outperformed strongly during the week off the back of weaker than expected Canadian employment data.

2.     Credit markets look orderly, despite equity panic

While there has been a certain degree of nervousness in the sterling credit market in February, the fall in bond prices should be viewed against the context of a strong performance in the latter half of 2017. While trading has been a little thinner, credit spreads are still fairly tight, and there has been none of the panic which infected equity markets during last week. European corporate bond markets look particularly robust and legacy tier 1 bank debt has remained pretty steady throughout this time.Some of the biggest moves in credit markets have been driven by other forces entirely. With twists worthy of a Scandinavian crime drama, Danish telecoms operator TDC’s bonds widen more than 100bps after it tried and failed to take over Swedish firm Modern Times Group, before itself being the subject to a bid by a trio of local pension funds working in consortium with infrastructure specialist Macquarie.

3.     Liquidity offers little comfort in high yield 

One of the most surprising outcomes of the sell-off was in the high yield market, where lower rated CCC bonds and emerging market paper were performing relatively well compared to BB rated assets. We think that both risk appetites and liquidity probably played a role here, with investment grade tourists selling off what would have been the riskier end of their portfolios. For traditional high yield managers, the tradability of these BB bonds might have made them a more natural sell as risk-averse investors withdrew money from portfolios.In addition, short dated assets with less sensitivity to rates and inflation tended to weather the recent turbulence more effectively. Many of these shorter dated bonds also have the potential to be called up early, offering issuers a chance to lock in cheap financing before yields rise further. 

While there has been some increased volatility in bond markets, the events of the last few weeks have demonstrated many of our convictions about the nature of fixed income investing. The premium placed on liquidity is often overstated, as events in high yield markets have proved, with more liquid bonds being disproportionately hit during the sell-off. 

Recent corporate failings at Carillion, whose various creditors look unlikely to recoup much of their capital, highlights the role that security over physical assets can play in helping to mitigate these risks. Above all else, current conditions highlight the benefits that being truly active can provide. Being able to choose to sell in light of corporate actions unfavourable to bondholders simply isn’t an option for benchmark-hugging passive investors. While quantitative easing has compressed yields indiscriminately, as this is withdrawn, investors will discover how well various assets fare without support from loose monetary policy.

Past performance is no guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.