Navigating through post-Brexit bonds

If fixed income markets were complicated prior to the British EU referendum, they most certainly are now, with investors hunting for safe haven assets as the prospect for further liquidity measures in the UK and even Europe increased.

For William de Vries, head of Fixed Income at Kempen Capital Management, the defining feature for current fixed income investors remains unchanged: The dominant
influence of monetary policy on the valuation of debt, paradoxically resulting in liquidity issues. “As a result of a large scale purchase of sovereign and corporate bonds, liquidity in the market decreases” he argues.

“There is certainly a gap in perception between regulators, who appear to believe that there is sufficient liquidity, and market practitioners, who keep pointing to the fact that there is insufficient liquidity in the market. Every practitioner I speak to argues that liquidity has declined significantly,” he stresses.

“As a result of Brexit, bonds are only traded in significantly smaller units and we keep wondering whether markets will be able to go on like this in the long run or if there could be cases of scarcity,” de Vries adds.

Amidst the uncertainty of the Brexit vote, yields on ten year Dutch sovereign bonds fell to -0.003% by mid- July. The persistently low yield is certainly bad news for
long-term investors such as Dutch pension funds; as of June 2016, their average coverage ratio stood at 97%, according to Aon Hewitt.

But despite record low yields, investors trading bonds before they matured actually received quite significant returns, as De Vries points out. “Returns on government bonds with a longer maturity have actually been brilliant, but of course it is now our responsibility to point out to our client that this is unlikely to remain the same.” For example, while yields for Dutch or German 30 year bonds were negligible, had they been bought at the beginning of 2016, trading gains would have been in the
two-digit figures.

With chances high that this trend might change, De Vries’ currently advises clients to hold a relatively higher percentage of cash. “There is very little demand among our clients for high yield or emerging market debt. I think that will only pick up once there is a correction in Europe,” he adds. “At Kempen, we made the decision to invest increasingly in corporate bonds. While we do still invest in sovereign bonds, the returns no longer stand in relation to the risks.”

“For European investors, the key factor will be to diversify their investments, and not to purely invest in euro denominated debt. This then generates better than anticipated returns and an opportunity to control currency and volatility risks,” he suggests.

Does he consider the risk that the Brexit impact could spread across the eurozone, with potentially disastrous consequences for European sovereign debt? De Vries remains sceptical, highlighting that the shock effect of the British vote might have acted as a deterrent. Nevertheless, he warns that there are certainly dangers.“Hatred of EU institutions has been stirred for a while now, so it is not surprising that people are very distrustful.

“Holding a referendum would definitely be a big challenge for the Netherlands, and it would be important to ensure that we define the question correctly, rather than basing it on emotions, as was the case in the UK.”

“Europe will have to seriously reconsider how it wants to proceed, but at the same time I doubt that the relationship with Britain will change significantly over the next two years. Yes, there will be a different status in negotiating trade deals but in some ways, Britain has always had a separate status. I am confident that we will still benefit from European integration in the long run,” he concludes.

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