Back to bond basics

Almost everyone expects yields at the top end of investment grade bonds to rise as money flows into cash to take advantage of better short-term rates. That is the theory, at least, but too much agreement is also a sign of a herd mentality (not one investment bank is calling for a fall in yields, according to bond specialists at Canaccord Genuity) and bond investors should in fact be looking to trade in and out of the investment grade market as gilts, Treasuries and bunds will be acutely sensitive to market sentiment, unlike high-yield bonds which will be less so. In such a finely balanced investment environment, it is worth going over the basics of the signs to look for in the sovereign bond market.

Duration, duration, duration

Most investors will access bonds through bond funds, rather than holding individual sovereign bonds. However, as Investors Chronicle reader Marc Van Oers recently pointed out to us, the mechanics of holding a bond fund differ considerably from owning an individual issue. For example, an often overlooked factor when it comes to bond fund investing is the importance of 'duration' as opposed to maturity. Mr Marc Van Oers writes: "I bet a lot of bond fund holders don't know the term duration and, moreover, will mix it up with maturity (the expiry date of a bond)."

Mr Oers is right to point out that there is a substantial difference between fund duration and the maturity of individual bonds. A fund's duration determines the level of on/off risk that the fund manager is prepared to tolerate in their fund. A short-duration fund of one year or less implies far less risk as the manager expects his current portfolio of bonds to reach maturity within that time, virtually guaranteeing the return of investors' money as short-duration bonds are far easier to trade. These will generally be price at, or near, par and will generally consist of easily traded major sovereign bonds. The basic mechanics of running the fund are simple as the bonds are replaced as they mature with bonds of a similar maturity to prevent the fund liquidating completely.

However, the impact of duration is far more profound than just forming a key part of picking individual bond funds. Taken as a whole it can determine the entire direction of sovereign bond yields for the year as fund managers, as a group, will decide how much duration risk their funds should be exposed to. This could potentially form part of a contrarian investment strategy for sovereign bonds if the economic news this year causes investors to hunt for safety. For example, Canaccord Genuity reckons that most bond fund managers are currently running either short duration bond portfolios, or are holding larger than average cash balances.

This seems to be part of the general expectation that sovereign yields will appreciate measurably by the end of the year. Better then, in this scenario, to own either cash or assets that can be quickly turned into cash. Canaccord's Mark Glowrey puts it like this: "The broad consensus tells us something about how managers' portfolios are constructed. With many light on duration or overweight cash, bond-positive news will have a tendency to spark decent rallies." Recent news that US-non farm payroll jobs created were far lower than analysts had expected came alongside statements from the European Central Bank that European rates will be held down as long as necessary. Taken together, this helped sovereign bond yields to contract - the benchmark 10-year Treasury bond retreated from its 3 per cent yield threshold in response.

In fact all the major sovereign bonds have staged stubbornly robust price rallies so far this year - the average rally is well over one point, with 10-year gilt contracts leading the way by staging a 1.63 point rally to 108. Where 10-year gilts head from here will depend on the underlying state of the economy but, according to Canaccord, the charts show technical resistance at a yield of around three per cent, with 2.6 per cent as a likely target for 10-year gilts, implying room for stronger prices in the short to medium term. All that is needed is for fund managers to rebalance their portfolios away from cash and sovereign bond prices will rise. The tricky part is deciding what will trigger such a change of direction, but the possibility that one of Europe's more troublesome economies might be the cause of a switchover to sovereign bonds is an ever-present threat.

The deflation paradox and sovereign bonds

One major factor to consider is whether the ECB will start to target bonds of countries with relatively robust economies for quantitative easing. One theory is that stronger countries such as Germany could be subjected to a narrow form of quantitative easing, instead of buying a broad spectrum of euro-issued bonds from all member states as happens at the moment. The effect of this would be to force Germany to reflate by opening up its tight fiscal policy in response and cause already low bund yields to fall further.

The aim of such a far-reaching change of policy would be to rescue southern Europe, not from high debts directly, but from the consequences of too low an inflation rate. Fathom Consulting reckons that Italy is particularly vulnerable to a prolonged period of low inflation; if its current inflation rate of 0.8 per cent were to stay unchanged in the short term then this, combined with the low rates of economic growth of the past three years, would send the country's national debt as a proportion of GDP spiralling out of control northwards of 180 per cent of GDP. This situation is a result of the European Monetary Union's inherent instability - without the mechanisms to allow fiscal transfers, or a full banking union, the ECB has little option but to continue to depress the interest rates for heavily indebted countries by whatever means necessary, which will continue to be good for sovereign bond prices.

EU sovereign bond yields

Superficially, at least, investors have been more than happy to buy the debt of Europe's problem periphery. Irish bonds, for example, are now trading at a yield of barely 2 per cent above Germany's rock-solid bunds. Even Greece, ludicrous as it now seems, can borrow from the market at 7 per cent, compared with nearly 30 per cent at the height of the euro crisis. The ECB's guarantee is one reason why markets have relaxed, but there are still anomalies that careful investors have to keep an eye on. For example, in Italy it is still currently cheaper for companies to borrow from the market than it is for the government.

That looks precarious if Fathom Consulting's estimates of inflation expectations are proved correct over the next 18 months, in which case bond prices for peripheral economies will fall, with a knock-on effect for 'safe haven' government bonds. In short, in spite of the expectations of generally higher yields, there are enough pressure points in the system to suggest that buying gilts, bunds and Treasuries should be on the agenda this year, particularly if money starts to flow out of equities.

Look at the earnings yield

It is isn't just the eurozone's problems that will determine the demand for sovereign issues. A key impact on the direction of the bond market will be the assessment of whether US equities have become significantly overvalued since their massive 30 per cent surge last year. The average PE ratio for the S&P 500 is currently 16, a level that historically it has only traded at for very short periods of time.

Market commentators are starting to talk seriously again about the expensive relative value of the earnings yield on the S&P 500 and the benchmark 10-year Treasury bond. In short, the earnings gap between equities and the equivalent bonds is at its lowest level in the US since 2011 at less than 325 basis points. This would suggest that share prices have outrun the natural value of the market and could herald a switch over into bonds as investors wait for earnings to catch up.

The possibility, therefore, that US investors will go long on bonds cannot be easily discounted, as the last time earnings were so compressed the S&P 500 staged its biggest retreat of the current bull market. Professional investors already seem to have noticed the trend as recent data compiled by the Federal Reserve showed that US pension funds have switched from equities to bonds in their greatest numbers since 2008. In addition, pension funds have also apparently been buying call options in large amounts - a bet that stock market gains will be limited - to finance even bigger government bond positions.

The equity risk premium narrows

The sheer size of the US bond market, and its impact on rates across the world, means investors here have to take careful note of such significant changes in sentiment. Gilt prices can and do move in step with Treasury bonds and any large-scale switchover into sovereigns will compress yields and provide opportunities for capital growth in the short term. Sovereign bonds should anyway have an important place in your portfolio. They can be used as an alternative to cash if short-dated and are a good way of reducing overall volatility, and there might be plenty of that this year.