Is the bonds bull market heading for a goring?
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Once seen as a rather uneventful corner of the investment world, fixed income now finds itself the subject of high-drama headlines, declaring “taper tantrums” and “bond bloodbaths”.
The root cause of the volatility has been the extraordinary response of the world’s central banks to the 2008 financial crisis. By slashing interest rates and pumping billions into bond markets, central bankers have given rise to a once-in-a-generation bull market in fixed income.
Yields are so low in some markets that many investors now fear the only way is up — and when yields rise, prices fall.
In early May, analysts at Morgan Stanley bearishly predicted that the US Federal Reserve, the European Central Bank and the Bank of Japan would all tighten their monetary policies in 2016 if growth continued to pick up.
When markets suspect that central banks will raise rates or taper their asset purchasing programmes this drives up the yields investors expect to receive from bonds. In other words, they throw a taper tantrum.
Morgan Stanley went so far as to warn that 2016 could be the year of the “triple taper tantrum” in bond markets, as interest rates rise and today’s historic-low yields become a thing of the past.
In fact, by the time the report came out the German government bond market was already throwing a tantrum of its own. The supposed safest assets in Europe saw their yields surge from lows of 0.05 per cent in April to above the 1 per cent mark by early June.
This translated to roughly a 7 per cent price fall suffered by investors in just over a month and a half, with knock-on effects throughout global markets.
To make matters worse, liquidity is scarce in many bond markets. This means that at times there are too few buyers and sellers willing to trade at viable prices.
Stewart Richardson, chief investment officer at RMG Wealth Management, says the central banks have artificially inflated price “bubbles in nearly all major assets and some minor and alternative ones as well”.
“This combination of extremely overvalued assets with poor liquidity becomes a major problem when enough investors want to cash in their chips and find there are simply not enough buyers at market prices,” says Mr Richardson.
“At the same time, regulators have changed the structure of markets, which has caused liquidity to become much more scarce.”
While the central bankers were pumping in cash, regulators responded to the 2008 crisis by imposing stringent new capital requirements on banks, forcing them to hold cash instead of “risk assets” like bonds.
In doing this, the regulators planned to turn the banks into safe and sturdy institutions, but the bond markets have been left with a dearth of available buyers at times of stress, leading to losses for investors.
Wealth managers are being forced to rewrite their investment rules books in response to these dual pressures in bond markets.
Private client giant Rathbones has introduced a new model, known as LED, under which portfolios are split into three distinct portions — liquidity assets, equity-type assets and diversifiers.
Bryn Jones, fixed income fund manager at Rathbones, says the new approach ensures all client bond portfolios have a significant portion invested in liquid assets. This ensures that reasonable prices can be achieved, in the event that assets must be sold off.
Mr Jones says the model also discourages investment managers from assuming bonds with currently low yield levels are therefore the safest and most liquid assets around, a potential pitfall with traditional bond risk models.
The presence of “diversifiers” reduces the risk of suffering painful losses in a market shock.
Diversified assets are those that tend not to fall in price in line with other assets at times of stress, although equally they may not rise to the same degree in bull markets.
Lee Morris, senior fixed interest investment manager at Canaccord Genuity Wealth, is another manager focusing on diversifiers to tackle the tantrums.
He says the firm is adding assets such as Qatari government bonds and so-called “dim sum bonds”, fixed income securities issued outside of mainland China, but issued in Chinese renminbi.
By buying up bonds that do not feature on major investment indices some of the worst volatility can be avoided, says Mr Morris, because the bonds avoid the “hot money” effect of the world’s major investors pouring into and out of the assets.
Buying short-dated bonds and holding them to maturity is another way to cut out the volatility, he says, as you are not exposed to the volatility of secondary markets.
“You will probably have to see a reversion to old-fashioned bond management — buying and holding bonds,” he says.
For access to the major markets Mr Morris recommends using “strategic bond funds”, many of which use sophisticated tools such as derivatives to reduce their exposure to central bank interest-rate policy.
The manager tips Jupiter’s Strategic Bond fund and GAM Star Credit Opportunities as leaders in the field.
While the wealth management industry is evolving in the face of volatility and illiquidity in fixed income markets, these tactics remain untested and there is no guarantee they will be effective.
For some investors, the next bond market downturn may prove to be a tantrum too far.
John Kenchington is the editor of Investment Adviser magazine