20 February 2013

The markets have their own form of gravity. What goes up (and up and up) must come down at some point.

While volatility, risk and big sell offs are associated with the stock market, the bond market is really no different—like any other market, it eventually succumbs to gravity. There are several catalysts for this reversal of momentum, including the end of easing,

It is no secret that yields are at historic lows, primarily due to zero interest rate policies (ZIRPs) and quantitative easing (QE) by the Federal Reserve and other central banks in the developed world. Safe haven demand, especially after the brutal volatility at the end of 2008 going into 2009, is also driving bond yields to record lows. As the economy and corporate sectors have stabilized and generated surplus cash, most of it is being invested in bonds, specifically bond funds.

However, ZIRP and QE are not going to continue indefinitely! While the Federal Reserve has stated that they will keep rates low through 2014, recent meeting minutes suggest that the Fed will begin increasing rates if unemployment crosses the 6.5% threshold. Levels are currently hovering around 8%, with a recent stall due to increased political risk and Hurricane Sandy. Expectations are that many of the political risks are dissipating, and underlying strength in housing, energy and other sectors in the U.S. will lead to more jobs and less unemployment.

Additionally, investors have been catching on to the fact that equities have been in a monster rally since 2009—what I like to call the Rodney Dangerfield rally, because it gets no respect. Corporate profits and cash are at or near to all time highs in the market, yet it has taken years for the fear to dissipate. This is reflected in mutual fund flows into bond funds versus stock funds.

In the 2012 calendar year, US$ 285.5 billion (net) flowed into bond mutual funds, while US$ 100 billion (net) flowed out of stock mutual funds. This trend has been consistent for most of the years since 2008, but 2012 represented the climax of bond buying. However, starting in November 2012, the tide started to change.

According to EPFR Research, which tracks fund flows, if we used November 21st as the starting point, and the last week of January as the end point, US$ 94 billion (net) flowed into stock mutual funds, while bond mutual funds received net inflows of US$ 35 billion. Stock mutual funds had their third best week of inflows ever, in the last week of January while the only segment of the bond market that is sustaining its level of inflows is Emerging Markets debt which has seen 34 straight weeks of net inflows.

The flow of funds is but one of the reasons why U.S. 10 year Treasury yields briefly surged above 2% at the end of January, visiting levels not seen in almost a year.

Yet, as seen from the 5 year chart, there is substantial room for yields and rates to go up further. This would impact VERY negatively on your portfolio if there is a high concentration in bonds and fixed income instruments, especially if you are holding the longer maturities (past 10 years).

DV01 is a metric that quantifies the dollar risk in duration; it is the amount of money that will be lost for every 1 million dollars invested in a fixed income instrument. DV01 for investment grade names in fixed income are in the US$ 770 area, well above their historical average of around US$ 600, according to data from Citi. DV01 has already been higher than US$800 in 2013, and because of their direct relationship to yields, will go back up if rates or inflation increase.

It goes without saying that record low yields coupled with dollar duration risk at multi-decade highs are not a good combination.

Dan Fuss, a low key but stellar bond fund manager who oversees $66 billion in assets at Loomis Sayles, in a recent interview on Bloomberg said that he has never seen a bond market that is so overvalued in his 55 year career. “What I tell my clients is, ‘It’s not the end of the world, but for heaven’s sakes don’t go out and borrow money to buy bonds right now,’” Fuss said, due largely to valuations he characterized as “ridiculous,” particularly in the new issues market.

Investment strategists at major investment banks such as Goldman Sachs and Citi have also sounded the alarms, not just due to fundamentals and the end of quantitative easing, but also due to the current structure of the fixed income market.

With regulatory changes and other shifts in risk appetite following the crisis, many broker dealers and investment banks have minimized the amount of fixed income inventory they hold on their balance sheet. This was part of the deleveraging that many institutions underwent in the wake of Lehman’s collapse.

In turn, funds and particularly exchange traded funds (ETFs) have become major players in the fixed income landscape, more than picking up for the slack from the banks and broker dealers. However, the ETFs have primarily been buyers until now.

Given that there has been so much overwhelming buying volume (the fund inflows), and that banks and dealers are now reluctant or unable to hold too many bonds on their balance sheet, what would happen in a scenario where rates or inflation expectations rise?

There would be a rush for the exit. Many of the funds and other institutions that have gorged themselves on hundreds of billions of dollars of bonds, like Life Insurance companies, would try to sell into that environment. But who would buy an overpriced bond with low yield and high dollar duration risk? Will banks get stuck catching the falling knives of the bond market? Those questions are difficult to answer, but it is even more difficult to see how they can be answered affirmatively.

Will there be a meltdown or will there be an orderly decline in the debt markets? It depends on whether you worship at the altar of Murphy’s Law. There is a saying about markets: that they can remain insane longer than you can remain solvent. There are arguments against a bond market collapse: many corporate and sovereigns have ample cash and may not need to issue debt; the economic recovery could stall, and in fact we could end up in another recession or financial crisis; war could break out between Iran and the West, or the situation in Syria can end up engulfing the Middle East in war, etc. These are all plausible scenarios.

The fact remains that there is very little upside in bonds, and the forces of gravity seem more and more inevitable with the passage of time: due to the end of QE and its potentially inflationary effects, due to high valuations and duration risk, and due to renewed confidence in the economic recovery and upside potential in equities. While there are scenarios that could support the bond market, such as the ones described above, they still remain less likely to happen.

Very few analysts believe that the credit markets will unravel tomorrow. But even fewer dispute that it is looking overheated, and many of the conditions that made it outperform in the past five to ten years are unsustainable.

Investors are advised to remain vigilant. Firstline is crafting strategies internally to grapple with some of these risks, and we are happy to discuss them with clients.

For More Information,

Please Contact Us At

Michael J Cooper
Trading / Investment Strategist
Firstline Securities Limited

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