Rules of work for bonds ‘thrown out of window’

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Last week was the equivalent of the ‘flash crash’ in US Treasuries.  We saw 10-Year Treasuries move from 220 to as low as 182 then back to 215 all in one day, which is not a healthy sign.  This in combination with poor economic data coming from Europe and fundamental issues weighing on investors created a toxic mix.

Running traditional fixed income today is very much about parsing the words of central bankers, whose policies effectively control the markets. But with the Federal Reserving prolonging the day of reckoning by refusing to raise rates despite the decent economy, the ‘follow-the-Fed’ investment strategy won’t work forever.

There are myriad challenges facing bond investors currently, all of which must be navigated carefully.  The most significant issues include:

  • Yields are compressed to near all time lows across the globe, compromising the ability of fixed income to provide any total return
  • Global economic and monetary policy divergence is becoming stark.  As the US economy is recovering quite well, the desynchronisation with regions like Europe and Japan is evident. This will cause some market distortions
  • Bond market volatility is certain to increase.  Limited dealer inventories mean that liquidity is stretched, a particular problem in markets like high yield, loans and convertibles
  • Correlations across sectors of fixed income have increased in the last few years. The tighter spreads become and the lower rates go, the more that the different sectors move in lockstep. As a result, in months like September, investors do not get the benefit of diversification.

To survive the volatility that is no doubt ahead in today’s markets, investors need flexible fixed income strategies that opportunistically draw on different sources of fixed income beta, lowly correlated alpha strategies, and the systematic use of hedging to diversify sources of return. They would do well to seek bond funds with low correlation to traditional fixed income and with the ability to deliver less volatility. And, most importantly, find a bond fund that can potentially deliver strong, uncorrelated returns even in the event of an upward move in interest rates.


Bill Eigen is manager of the JP Morgan  Funds – Income Opportunities Fund

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