David Roberts

Finding relative value in bonds (or what to do when the world is against you)

David Roberts

We often think of bond markets as a homogeneous mass, while equities are alleged to be a bit more disparate. This is despite the fact that we have seen plenty of examples, including very recently, of equity markets displaying a herd instinct.

I am a firm believer in the inefficiency of markets and, therefore, I do believe fixed income as well as equities can offer opportunities to investors to make money even if the general level of prices in a particular market looks a bit steep. These inefficiencies can extend through the global to the regional and ultimately company level. In this article, I highlight a few of the “macro” imbalances I believe investors can currently benefit from exploiting.

An end to quantitative easing? Yes, ja, yeah and oui but no sayonara

After a decade of central bank-sponsored rallies, bond markets have fallen a little in price and yields have risen since September 2017. Investors have questioned the wisdom of buying an asset class still close to record high prices at a time when growth and inflation globally are around long-term trend levels.

The supply and demand imbalance in the bond market of the past 10 years looks set to recede. But even here, we may have an opportunity. The Federal Reserve and Bank of England have had enough, and even the European Central Bank (ECB) looks likely to step down quantitative easing (QE) come September. However, as late as last week, the Bank of Japan reaffirmed its policy of controlling market rates, committing billions of yen to defend yield ranges.

There are also some signs of nascent fiscal stimulus, however, which even if badly targeted, may promulgate the economic cycle and stoke inflation. This means even the comparatively small back up in bond yields seen so far may not be enough to make the broad asset class cheap enough for many investors.

If the market is rich, should we just avoid it?

I would argue that if yields rise further from here, then simply buying bonds or bond funds without understanding the specific mandate’s flexibility is not sensible except for the longest of long-term investors. That though is only part of the story.

Core US Treasury yields have already risen to around 3%. Solid investment grade companies are paying nearly 4.5% a year to borrow for 10 years. Anyone buying today could still see a short-term capital loss as market yields move higher. However, a yield of 4.5% coupled with a very low chance of default means the likelihood of beating cash on a 12-month view is very high.

In addition to this so-called “carry” argument, recent volatility and disparate central bank action has created numerous relative value opportunities in the market. Such opportunities may afford investors the chance to make a positive total return without taking material directional risk. I’ve listed three of the more obvious candidates here and each involves reduced directional risk compared with simply buying the market.

1: Not all sovereign bonds are the same

UK Government bonds look blindingly expensive. I know we have had QE and are still wrestling with Brexit but domestic inflation is well above target and may yet surprise further. Plus, international investors have traditionally demanded a premium for the inflation and political risk of owning UK bonds versus their US counterparts. Mr Trump may have rebalanced the political element, of course, but, going back to the late 1980s, investors wanted, on average, 0.5% more yield each year to own gilts than treasuries.

Chart 1: UK 10-year Gilt yields less than US 10-year Treasury yields

Chart 1: UK 10-year Gilt yields less US 10-year Treasury yields 

Source: Bloomberg, as at 09.02.18. Chart shows the difference between ten-year UK gilt yields and ten-year US treasury yields in basis points (1%=100 basis points). At the time of writing, 10-year gilts ‘paid’ 1.24% (124 basis points) less than similar maturity US treasuries.

At present, that relationship has flipped over and we can now earn more buying US assets. Will this unwind soon? That’s a good question – it does appear the Bank of England is starting to understand the importance of raising rates soon. Should this relationship move back to the average of the past 30 years, US bonds would outperform the UK by around 15%. This offers equity-like potential returns with more liquidity.

2: Isn’t financial debt supposed to be cheap?

Bonds issued by banks and other financial companies often fail to make it into central bank buying programs. To that extent, there is a general view their debt is “cheap”, or at least closer to fair value than other parts of the market. This is especially true in Europe.

I like chart 2 below, which looks at “crossover” bonds – normally core industrial names rated around the BBB level, so they are supposedly riskier and more volatile than the market average. This index also includes a few financials and I ran an analysis against a pure index of subordinated financial debt.

Chart 2: Itraxx XO and itraxx Sub Financials: one-year spread history

Chart 2: Itraxx XO and itraxx Sub Financials: one-year spread history

Source: Bloomberg, as at 09.02.18. Chart shows crossover bond credit spreads versus financial bond credit spreads (again in basis points). Spreads are the yield on these bonds over that available on government debt of similar maturity.

Lo and behold, over the past 12 months, financials have become much more expensive: the yield differential moving from about 0.6% to over 1.5%. Yet neither series has been immune from the sell off of recent days. Of course, while this example collapses overall market direction, it is a play on two different parts of the market, one concentrated in a single sector, the other reasonably well diversified and yielding 1.5% a year more.

Unlike many in the market today, I well remember 2008 and really don’t want to be on the wrong side of a systemic sectoral collapse. Diversification and yield pick up: I like it.

3: And, finally, Japan anyone?

This is my thirtieth year working in financial markets. In all that time, seldom have I seen fit to own Japanese debt. But perhaps there is an opportunity?

Last week, the Bank of Japan (BOJ) reiterated its intention to defend the bond market. More explicitly, it committed to holding 10-year yields at or below 0.1%. Surely at that level there is no way to make money? I need to be clear here – I can see opportunities to benefit either from long or short positions in the trade. However, and I guess this is part of the point of this article, opportunity is everywhere, you just need to analyse each and then have the flexibility and willingness to take the correct path.

Chart 3 compares Japanese and US bond prices over the past couple of years. As you can see, Japanese Government Bonds (JGBs) have been incredibly stable as the BOJ has intervened to prevent price movement. On the other hand, the eight-year US bond I’ve referenced is 6% down since September.

So, in pure yield terms, I could earn 2.6% owning the US security and take the volatility – however, if market yields rise to 2.8% then my total return over one year is zero, which is more or less what I’d make from the JGB.

Now, here’s the thing – I hate currency. It adds another layer of risk to portfolios. If I bought the Japanese bond, I would sell the currency risk “forward” to remove that risk. For doing so, the kind people in the foreign exchange market pay me about 2.4% to take my yen from me.

Chart 3: US and Japanese 2025 maturity debt, two-year history

Chart 3: US and Japanese 2025 maturity debt, two-year history

Source: Bloomberg, as at 09.02.18. Chart shows price of US Treasuries versus Japanese Government Bonds over the last two years. Treasury prices are on the left axis and JGBs on the right. This shows the price to buy $100 of the US bond is now just over $96, while the Japanese bond is 103 yen for 100 yen of the bond.

All of a sudden I can choose: own the Japanese bond and be paid about 2.4% or receive 2.6% to own the US equivalent.

What would you choose? Well, if you think US rate volatility will continue, you don’t want to hold Treasuries. If you believe the BOJ will hold the line then you have a low volatility instrument giving you a 2.4% return.

Doesn’t that give market direction? Yes, it does – owning the Japanese bond creates duration. To deal with this, one sells US Treasury futures. That changes the nature of the trade and we need US bonds to modestly underperform Japanese ones to make money. Of course, we might think US bonds are cheap enough already and buy those, selling Japan to remove duration that way. Simple isn’t it?

And there are more

I think three opportunities are enough to be going on with. Plenty of people have talked about how expensive emerging market debt is and many are concerned the ECB has manipulated the euro credit market, creating a value trap. I’d happily short either against US high yield or UK investment grade but those are well discussed strategies.

Make sure you can capture these opportunities

I have looked at three examples where bond investors could make money even if the overall level of the market looks expensive. Of course, there are a number of assumptions baked into this free lunch, few of which may transpire. Key, of course, is having the capability to target these opportunities, which I believe is where a proper, old-fashioned strategic bond fund comes in.

The opportunities above are all “macro” in nature and just a small sample of those available. We can also seek to take advantage of bottom-up, microeconomic opportunities but that’s for another day. Suffice it to say that as volatility rises and assets generally look expensive, it is essential for investors to maximise returns in a risk- controlled manner. Combining beta flexibility (overall market risk) with macro and micro alpha positions (opportunities for excess returns) is a great starting point.


Key Risks & Disclaimer

Please remember that past performance is not a guide to future performance and the value of an investment and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital.

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Wednesday, February 14, 2018, 5:09 PM