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When it comes to bonds life is not so simple

25 June 2018

David Jane, manager of Miton’s multi-asset fund range, examines the implications of the European Central Bank’s moves on the bond markets

In the latest ECB announcement, Mario Draghi, true to form, performed his classic trick of pleasing all parties with the ECB announcement, while saying little new of substance. On the positive side, he said that rate rises would not be occurring until late 2019 at the earliest, while on the other side he announced that there would be no extension of the current QE programme. What are the implications of these moves?

The effect of the QE programme in Europe has been to hold interest rates extremely low right along the yield curve and to compress credit spreads to levels, which look in many cases unjustifiable.

More subtly, through the bond buying programme, the ECB has been a consistent buyer of European investment grade bonds both in the primary and secondary market, to the extent that it is now a significant owner of the outstanding market. While there’s no plan for it to sell its positions, and indeed it will reinvest the proceeds of maturities for the foreseeable future, the absence of a big buyer must change market dynamics significantly.

Another often misunderstood feature of the market is the relationship between credit spreads and interest rates. Received wisdom says that as interest rates fall, credit spreads widen and vice versa, marking corporate bonds an attractive investment as they smooth the impact of the rate cycle on total returns. This thesis is similar to the idea that when bond yields rise equities will be rising, the risk parity thesis, which sits under many asset allocation strategies.

Unfortunately, life is not so simple, as we saw when the US bond yield moved rapidly higher in the early part of this year and equity markets fell, proving risk parity to be a fair weather friend at best. The same is true of the spread, yield relationship: it holds sometimes and not others. As rates have moved ever lower in Europe, credit spreads have become ever more compressed.

The simple risk models have failed to take account of two factors which are new in the post QE environment. One is yield tourism as investors finding income scarce have been pushed to ever riskier bonds. The other is the impact of credit derivatives, which have become an ever more mainstream instrument. Similar to equity options, a key part of the valuation is interest rates and volatility; and volatility, being a tradeable asset, is itself a function of interest rates. As rates have fallen, the attraction of selling credit derivatives has risen despite the falling credit spreads, somewhat counter-intuitively to a fundamental driven investor. As rates rise, the reverse will become true and credit spreads will rise, possibly materially, despite the likelihood of this occurring in a benign or even strong economic environment.

So, there are a couple of significant reasons why the bull market in European credit is likely to have ended and indeed we are already seeing spreads in Europe widen as the market anticipates the inevitable. We doubt there will be a rout however, as financial instability is the very thing the central bankers are most afraid of, but more a gentle but consistent loss of capital over an extended period bringing valuations levels to a place where a rational investor might buy. Does this have any broader implications for markets? We doubt it, similar to the ending of the VIX bubble, we see the recent actions in emerging markets and elsewhere as a general normalisation of markets rather than a reason to panic.

During the Eurozone QE era, interest rates have been low and assets have been priced off these low rates so valuations have appeared sensible to a relative investor but daft to an absolute investor. Many investors have only seen this world; we would welcome a return to sensible absolute levels of valuation. Our funds have no exposure to euro denominated credit and little exposure to rising credit spreads elsewhere as we hold few longer dated bonds and have little exposure to companies with high borrowing levels.

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