Bond markets alternate between panic and greed

John Redwood, picture for Money FT byline

The notional FT fund has had a good 12 months. The investments in China and Japan have been particularly good contributors, helping the fund to an overall return of 10 per cent.

This positive performance is despite bad news in the bond market. So-called defensive lower risk funds have struggled in recent weeks. Most have very high levels of investment in bonds which are meant to be more stable than shares and used to offer a reasonable running income. When interest rates rise from unusually low levels or when the bond market has a bad time they do not protect your capital as you hope.

The bonds in this portfolio have not been great in recent weeks either. Running a balanced fund, you have to keep a minimum in bonds. I have kept it to the minimum allowed under typical balanced fund rules. The guideline for a balanced fund is 50 per cent in bonds, so I have run it at 40 per cent, which is the usual lowest level permitted.

It’s been difficult to know what to buy and hold when interest rates are so low and prospects are not good for capital gains. I have kept the bonds balanced themselves, with a mixture of index linked longer bonds, short dated corporates, average gilts and some higher yielding emerging market paper. They have all had their off days. Perversely at a time of very low inflation, the index linked ones had more good days than the others, performing very strongly over last year as a whole, but they too fell sharply in recent weeks.

I talk to professional bond managers. The optimistic ones suggest various strategies to make money when bond markets overall are going nowhere or even going down. Some say one should take more risk by buying loans to companies that have weaker balance sheets. This does give you more income. Running more credit risk at this stage of the economic cycle in the west can make sense, as profit and cash flow generally is improving so risk of bankruptcy reduces overall.

However, the crash of oil and commodity prices should remind investors that there can still be large losses in parts of a growing economy which can bring down companies. Selling some of these corporate bonds again when the interest rate cycle does change decisively may not be easy. The fund holds an exchange traded fund of decent quality, shorter-dated corporate debt which gives it a bit more flexibility to sell when need arises.

IShares 1-5 GB corporate bond fund has been the best of a bad lot in the bond section of the portfolio in recent weeks. It is the fund’s largest bond holding at 14 per cent of the total portfolio, designed to be more stable when markets take fright.

Some say buy longer-dated bonds. This too gives you a higher income, but you will lose more money more quickly when official interest rates rise or when the bond market gets the jitters. Some say buy short-dated bonds and stay short to limit your losses. This works in adverse conditions, though you may still lose some money.

Others try to make the week-by-week calls, as these bond markets are now volatile and offer trading opportunities to the skilled or the lucky. It’s no easy task to read these markets, which alternate between panic and greed. Many expect dull reliable bonds to remain reasonably stable for long periods. Sometimes sedate high-grade sovereign bonds can become wild bucking broncos instead.

You would have thought with all that quantitative easing money sloshing around, and with the large bond positions owned by many pension funds and insurance companies, that there would be a good two-way market in bonds

The first thing to worry about with bonds is the lack of liquidity in modern bond markets. You would have thought with all that quantitative easing money sloshing around, and with the large bond positions owned by many pension funds and insurance companies, that there would be a good two-way market in bonds.

The new and tougher regulations on the banking sector have greatly compressed the books of the leading bond traders. If a largish seller or buyer emerges it can generate substantial movements in prices, as the banks are unwilling or unable to finance large positions either way. If this persists for a few days then it can lead to a change of mood in the markets, and generate a lot more one-way trade, which will impel prices more swiftly in the chosen direction. Once enough people think current bond yields are too low and should go higher, the correction could take place quickly, with the market hard-pressed to absorb all the selling.

The second thing to worry about is the absence of income on many of the high quality bonds. Even after the price falls of the past two months, a bond buyer is lending their money to Germany for almost nothing, and to the UK and the US for around 2 per cent for 10 years. It’s not a great forecast return, and is well below the income levels you expected from bonds in preceding decades.

Gone are the days when you could lock yourself into a 4 per cent or 5 per cent running income, and look forward to the possibility of additional capital gains if interest rates fell. From here, there could be trading gains when markets remember just how low yields can go, and are impressed again by the large buying programmes of the Japanese and European central banks, but the scope for gains and the probability of them is much reduced by the low starting yields.

The third source of concern is that the very low levels of historic inflation and the recent fears about deflation are now receding. Were inflation to pick up in the US and the UK as wages start to rise more rapidly, investors would be more worried about the very low levels of income on conventional bonds.

There are modest signs of a small increase in pay, despite the creation of ever more low paid jobs in both economies. Poor rates of productivity growth also add to the inflationary fears. Real yields on inflation adjusted bonds are negative. The current 2 per cent yield on a 10-year UK government bond is well ahead of inflation. Investors seem to think inflation will rise, making more sense of the different valuations accorded to inflation linked and ordinary bonds.

These bonds are far from normal, and offer a poor running return. I wonder how long the natural buying by pension funds and risk-rated balanced funds will continue, if a major bear market in them sets in? Much of the research showing you need plenty of bonds in a balanced or pension portfolio is based on past years of bond bull markets, when bonds gave a better starting income and good capital gains.

I remain a nervous and unconvinced holder, mainly swayed by the rules of balanced funds to keep the holdings. The authorities seem to want to keep interest rates lower for longer, and inflation remains low, so there is some comfort still left for lovers of bonds. I look to the shares in the fund to make the return investors want. Conditions still seem reasonable for share investing, with some growth in prospect.

All main country governments want to promote expansion, and the major central banks continue to ease money. Growth is proceeding, but not at a pace to alarm the authorities or to push them into rapid and large rises in interest rates designed to stop the recovery. However, shares now have to handle the sell-off in the bond markets which casts a shadow over them as well.

John Redwood chairs the investment committee at Charles Stanley Pan Asset. The contents of this article are for general information only and do not constitute investment advice


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