David Roberts

How to make money from bonds in a falling market

David Roberts

With so much talk about worsening conditions for bonds, investors are understandably questioning how they can make money from fixed income funds in a falling market.

For us, a key strategy to achieve this is by maintaining beta-light portfolios: the simple fact is that all government markets are currently expensive relative to long-run averages. US 10-year yields have started to move higher since the Federal Reserve increased interest rates but this hardly shows up in the longer-term charts.

 David Roberts: how to make money from  bonds in a falling market

Source: Bloomberg, as at 14.06.18

Further moves toward the ‘old normal’ will mean capital losses for investors, who have had a great run from bonds thanks in large part to central bank market manipulation. As those banks start to tighten policy, bond investors can still make money but we are only expecting positive beta in the US over the coming 12 months, as the country is further down the normalisation path, with largely negative market returns elsewhere.

Unless economic cycles really have broken down – and there is close to zero evidence of that – interest rates are moving higher. Most G7 central banks are now facing a mild inflationary problem, and we believe they learned the lessons of 2008 and will not allow economies to materially overheat. Propping up asset prices at the expense of the real economy simply increases the probability of another global financial crisis.

This backdrop has encouraged us to remove directionality from our portfolios, largely replacing beta with many of the alpha opportunities we see across markets. Rate cycles are out of sync as central banks wean us off quantitative easing (QE) at varying speeds and this is great for active investors, with bonds in countries from Japan to Germany hardly moving in price.

Where the US leads, the rest of the bond world almost inevitably follows and there have rarely been so many cross-market opportunities. The following outlines three current positions in the portfolios where we see value in long/short pairs.


1) Long Norway, short France

 David Roberts: how to make money from  bonds in a falling market

Source: Bloomberg, as at 14.06.18

French bonds have benefited hugely from the ‘Macron effect’ since he won power last year and are trading at the tightest spread in a decade to Germany. Norwegian debt meanwhile has suffered as the Central Bank changed its inflation target – a misread by investors. Yet despite paying us 100% more than France (1.4% versus 0.7%), Norwegian debt is less volatile and less exposed to an Italian-style crisis.


2) Long US, short Canada

 David Roberts: how to make money from  bonds in a falling market

Source: Bloomberg, as at 14.06.18

We are normally paid more to own Canadian debt than American. But the combination of commodity weakness (a year ago) and trade disputes (seen as deflationary for Canada) means we are currently buying American and selling Canadian to be paid more than at almost any time in the past 30 years.

 

3) UK versus USA: The Brexit effect

 David Roberts: how to make money from  bonds in a falling market

Source; Bloomberg, as at 14.06.18

I am using the US in another example and make no apology for that: Treasuries really are as cheap as chips compared with other G7 bonds.

Bank of England manipulation, and I would suggest dangerous monetary management, leaves gilt yields an astounding 1.5% lower than US equivalents. Two questions to consider: which of these two economies currently has higher inflation and which has called in the International Monetary Fund in the past 50 years?

In summary then, we remain beta light across the funds, with around three years’ duration against a long-term average of 4.5 and a global market at six.

The US is furthest through the rate-hiking cycle and while we see some absolute value there, there is plenty of relative value: the winner of the least ugly contest if you will. Rate markets are all tuned to the same cycle, it is just that some are further through it than others.

As we move back towards old normal conditions, there is money to be made in bonds but beta looks expensive so we are substituting this risk with the abundant alpha available. The market remains dislocated globally thanks to central banks moving at different speeds, which we believe offers plenty for an active manager to exploit.

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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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Thursday, June 21, 2018, 2:10 PM