AXA IM: Bond Bubble? Fixed income investing in an ‘expensive’ bond world

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Nick Hayes, manager of the AXA WF Global Strategic Bonds comments  why investors should be considering yield give-up rather than yield pick-up.

We are living in extraordinary times1:

  • 25% of European Government bonds have negative yield;
  • 10 year German Bunds are yielding 30 basis points (bp)
  • Sterling credit had its best ever month in January 2015, +4.9%, whilst its yield was at its lowest ever point (3.3%).

“I’m not sure which of those facts is the most shocking.  I see a big disconnect between economic fundamentals and asset prices, demonstrated best by the yields on Government bonds. As the US and the UK approach the transition to a post QE world, and their respective first interest rate rise, it’s the QE from ECB and Japan that is keeping yields at such low levels.

“Increasingly fixed income valuations are being distorted by the supply demand dynamic skewed towards lower yield, in some cases lowest yield ever which goes back to 500 years of historic data! 2014 saw a combination of the market lowering expectation of where the peak in interest rate cycle would be, but also a strong consensual positioning of being short duration which was painful as yield rallied, and led to further buying as investors closed underweight positions.

What makes yields go higher?

“I’ve long resisted likening the bond rally to a ‘bubble’ but we are certainly seeing some pretty extraordinary events that make us question what’s going on. The comfort with which investors are embracing negative yields is certainly of some concern. What I think we are also seeing is the “capitulation” phase. Similar to being underweight technology stocks in 1999, it’s the phase that says “maybe I should just buy these IPO’s because they always seem to go up, even if the economic fundamentals are poor”. This capitulation phase is important because it helps market positioning. As opposed to 2014 where the consensual underweight duration meant that the market was nearly all faced the same way, we are now seeing a much more balanced market and a growing support that believes that bonds can keep going lower in yield. As such, like the Nasdaq in 2000, maybe the market will just fall in on itself and rising yields will be met with little resistance.

So how are we positioned?

“Global Fixed income is such a diverse asset class that you can’t just say “bonds are in a bubble” and ignore the asset class. We look at interest rate and credit sensitive bonds, long and short maturity, conventional and index-linked assets, let alone geographic diversification. With yields at such low extremes we definitely prefer bonds of shorter maturity and continue to avoid long dated Government bond assets that have rallied so aggressively in recent months. In addition we like credit, specifically US high yield, but when the overall reference valuation point (US treasuries) for all Fixed income is ‘expensive’, I believe that it’s fair to assume a re-pricing of US treasuries, and other core Government bonds, could lead to a selloff in most of the asset class.

“Importantly then we are pretty defensively positioned in both Government bonds and credit. For me 2015 should be about “Yield give up” not “yield pickup”. Over the last 5 years investors have been rewarded well for ‘hunting for yield’ in fixed income. Buying the higher yielding assets, whether they be credit or interest rate sensitive assets and reaping the benefits of a bond rally. In 2015 I’m looking to buy the lowest yielding assets, that importantly are also carrying a low level of risk. Its building the core of the portfolio around the lowest beta part of fixed income, short dated, lower risk bonds. Ultimately this means the lowest yielders. I look for opportunities to add some more attractive parts of fixed income around that, some financials or US high yield, but more importantly waiting for the opportunity to buy higher yielding assets once a sell off comes. Whether that sell off comes in Government bonds, or credit, or both remains to be seen, but with such extraordinary gains over the last few years I wouldn’t rule out it being in both.”

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