Four myths about bond investing – JP Morgan’s Eigen explains
Bill Eigen, fund manager, JP Morgan Funds – Income Opportunity Fund, explains why conventional wisdom about rates staying low may be short sighted.
Surprisingly strong fixed income markets have made investors complacent towards risk. This is a mistake. It is short sighted to believe that rates will inevitably remain low and investors need to be seeking diversification from traditional fixed income.
Lower rates in 2014 can be attributed to several exogenous factors. Geopolitical tensions triggered a flight-to-quality by global investors. Central bank policy has also remained extremely accommodative, keeping rates anchored. Finally, difficult weather in the US contributed to disappointing GDP growth and some focused on that weakness as justification for why rates are likely to remain at current low levels, if not decline further. Again, this is mistaken.
The US shrugged off the cold start to the year and the economy expanded by 4% on an annualised basis in the second quarter, well above market expectations. The stronger than expected rebound highlights just how distorted the first quarter figures were by one-off events. Short-term interest rates have already drifted higher reflecting the potential Fed tightening next year.
To illustrate how precarious betting on rates is, at current levels, even an increase of just 14 bps in the 10-year yield or 7 bps in the 30-year yield would wipe out the coupon income earned in the second half of this year and cause principal loss. Consider that the last time the Fed alluded to changing macroeconomic policy (May 2013), long-term rates rose by over 100 bps. Investors saw how losses can be magnified when rates rise and the offsetting income is small.
These losses were not limited to Treasuries, underscoring that it is not possible for investors to hide in the traditional long-only diversification strategies that have worked well in the past. Spreads across all sectors have compressed to the point where sectors exhibit high correlation across the board, offering virtually no possibility of a differentiated return stream in a less benign rate environment.
The conventional wisdom we question below is not to scare investors out of the market, but to support the case for seeking diversification to traditional fixed income solutions via strategies that don’t rely on falling rates to generate the low volatility, steady returns that fixed income has produced historically.
Why the conventional wisdom about bonds is wrong
A number of explanations have been offered as to why this low-yield environment will continue. We examine a few of these common themes and illustrate why we believe them to be short sighted.
Myth: When choosing among “risk-free” assets globally, US Treasuries provide higher yields than other sovereign bonds of similar quality. German Bunds—a common alternative in terms of safety and liquidity—offer yields that are more than 1% lower than US Treasuries. US Treasury yields will remain low until other regions recover.
Reality: In an efficient market, interest rates reflect expectations for economic output (GDP) growth and inflation. The argument above looks only at nominal yields, while investors typically seek the highest real (inflation-adjusted) yields possible. Rates in Europe are lower partly because inflation and GDP growth remain and are expected to remain low. Year-over-year, eurozone inflation stands at 0.5% while annualized GDP growth recently came in at 0.9%. Current forecasts are for inflation to remain below 1% in the near term and growth to remain muted. Conversely, US rates do not properly reflect the moderate GDP growth and higher inflation that is expected in the second half of 2014. Therefore, US nominal yields are trading at “discounted” levels to what the appropriate real yield should represent. Diverging growth patterns mean the eventual untethering of yields.
Myth: New monikers such as the “new neutral” have been used to describe a low-yield environment driven by weak global growth, changing demographics, and loose central bank policy. Therefore, investors can be less concerned about interest rate risk, considering subdued future growth expectations.
Reality: Projecting long-term economic growth rates with any precision is extremely difficult and unconstructive. Predicting factors such as central bank policy, housing market growth and capital expenditures that determine long-term growth rates years into the future can be futile. Even when armed with data, investors have a history of undershooting fed funds rate changes. In the last Fed tightening cycle, the market’s expectations of the timing and magnitude of fed funds rate changes fell short. We believe this same dynamic is occurring again today. The Fed has stated a target of a 2.5% for the fed funds rate by the end of 2016 while the market’s priced-in expectation is 1.75%.
Myth: A shrinking US deficit means less debt issued by the US government. Demand has increased from foreign buyers looking to manage reserves and healthier pension plans moving away from risk assets. These favorable technicals will continue to keep rates anchored.
Reality: While the US deficit has shrunk, the debt burden is still massive; servicing that debt will be a monumental task requiring more debt to be issued. This will lead to a healthy supply of US Treasuries as the country continues to fund its debts.
While headlines talk about pension demand for Treasuries, the data does not support it. Pension plans represented just 4% of the owners of US Treasuries in 2013. Pensions also continue to decrease in size and scope as companies shift to defined contribution (401(k)) plans. Meanwhile, the Fed has been the largest buyer of Treasuries; it accounted for most of the net purchases in 2013. With the Fed leaving the market as quantitative easing (QE) is expected to wind down, who will come in and pick up the slack? A waning of demand could force rates higher in order for new debt to be absorbed by the mark
Myth: The Federal Reserve is committed to keeping interest rates low, market volatility muted, and risk assets attractive. We can expect several more years of accommodative action and dovish rhetoric.
Reality: While the Fed can be committed in the short term, the economy may force its hand. The labor market has improved markedly over the last few months, inflation has drifted higher (March through May CPI readings annualize to a trend of 3.2% per year) and the economy is poised for stronger growth. The Fed is still implementing credit-crisis-like policy, while the pattern of moderate economic growth suggests that it may be superfluous. Ultra-low rates for the last six years and massive amounts of quantitative easing will need to be unwound. As growth becomes more consistent, the Fed may be forced to tighten quicker than anticipated.
While the macroeconomic environment remains difficult to navigate, it is important not to lose sight of why investors hold fixed income in the first place; to protect capital, to lower volatility, and to diversify other risks (i.e., equity risk) in overall portfolios. Traditional fixed income has done well given the unexpectedly benign rate environment this year. Should the rally from the first half of the year prove to be unsustainable, however, those gains may prove exceptionally transient. Fixed income investors should ensure that their portfolios are sufficiently diversified and not lose sight of the fact that fundamentals are likely to win in the end.