By Jan Straatman
At the height of the sub-prime bubble Citigroup chief Chuck Prince famously said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Six years later, the world’s central banks are playing a different tune with quantitative easing and ultra-low interest rates. Bond investors are doing a more frantic dance as they search for yield. But what happens when the music eventually stops – as it must do?
Don’t be fooled by the current artificially- induced low volatility. This is a game-changer for fixed income markets. Risk-aware bond managers today need to be nimble and equipped with the full range of tools to manage maturity, credit and inflation risks. Bond investors without this flexibility are dangerously exposed.
Central banks’ aim is to keep policy accommodative in the absence of growth, leading to the view that it will be a while before they withdraw liquidity and interest rates rise to normal levels. The risk/ reward balance in bonds is now skewed towards risk. So investors need to think less about timing and more about what happens when rates rise, certainly before the inevitable rush for the bond market exit when policymakers’ behaviour changes.
This asymmetric risk-reward trade-off, created by an environment of possible policy mistakes, low-growth and high and rising debt ratios in advanced economies, means that the traditional long-only bond approach exposes investors to heavy losses when the liquidity supplied by central banks evaporates.
A Total Rate of Return (TRR) approach can benefit from rallies while ensuring that when rates rise the portfolio still delivers a positive return. It may mean exposure to 5-year bonds with good fundamentals, but with the shortish maturity risk hedged out by using swaps. Or it may mean exposure to the increasing demand for higher-yielding but lower-rated corporate bonds; or owning broad inflation protection by creating synthetic inflation- linked bonds where ready-made linkers are not available, as in the Netherlands.
These techniques, as well as interest rate futures, floating rate notes and credit default swaps can all be used to alter a portfolio’s interest rate and credit sensitivity, giving investors a positive return uncorrelated to the underlying investment cycle.
At some point central banks will look to unwind their unprecedented experiment in unconventional monetary policy. Widespread quantitative easing has left central banks with very large balance sheets and as owners of vast piles of government debt. There is no historical precedent for how bond markets will react as central banks manage their exit, particularly given that they may own the majority of outstanding issuance in some longer-term maturing bonds.
The risk of a policy mistake, consequently, is far higher. Take what happened in early 2013 in the UK. Talk that the Bank of England might target nominal GDP was seen as a step towards dropping the 2% inflation target. The resulting short-term price falls in UK government bonds and sterling underlined the dangers of poor central bank communication.
The fear of an eventual resurgence in inflation expectations is not confined to the UK. Signs of inflation are already emerging in the US where residential house price inflation is currently running at an annualised rate of more than 9%, the highest level since 2006.
It’s not a pretty outlook for bond markets. Just as armies tend to be perfectly equipped to fight the war just ended, but woefully underequipped to fight the next, bond investors need to embrace a new, less familiar approach. This needs to be agnostic to the shape and timing of the interest rate cycle but able to generate cash-plus returns by offering the ability to go short; as well as focusing on relative value opportunities arising from market inefficiencies and mispricings.
Jan Straatman is CIO at Lombard Odier Investment Managers
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