The Bond market rally shows no sign of ending
Kellie Wood discusses the fixed interest market reaction to Brexit including another major bond yield falling into negative territory. Learn why in this fragile environment the portfolio manager is positioned with the longest duration the Fund has had since the Strategy’s inception.
The bond market rally shows no sign of ending in spite of disappearing yields. The benchmark European bond yield (the yield of the German 10yr Bund) traded into negative territory for the first time in June, joining the Japanese and leaving the US as the only G3 country with positive yields and a market dynamic resembling anywhere near normal.
Normality is certainly a concept we, and others, have been wrestling with. Our longer term fair value bond models assume both a return to economic normality (albeit a more subdued one than in prior decades) and a resumption of the typical relationship between economic and market variables. These assumptions are being challenged by current market conditions and very dovish central banks.
Frustrating a return to economic normality has been a weak global cycle, where although growth outturns have been about trend, this has undershot considering the stimulus applied. Meanwhile, central banks, in applying the stimulus, and an acute savings-investment imbalance, have stretched links between the usual economic variables and bond market yields. Several events over the quarter helped contribute to concern about aggregate global weakness and reinforced the ‘lower for longer’ mentality – notably US employment data turning softer, the RBA’s self-downgrade of their ability to generate inflation, and of course the Brexit vote.
For some time we’ve been acknowledging that in spite of structural expensiveness, bonds were unlikely to have a significant cyclically-driven sell-off because of the fragility of the global recovery. Consequently we’ve been progressively reducing our aggregate short duration position since late 2015. However June quarter developments saw us moderate our short duration position further, such that we ended the quarter only 0.50 years shorter than benchmark. It’s worth noting that with benchmark duration lengthening materially as the government has both increased and termed out its debt, current duration is the longest it’s been since the Strategy’s inception. We are slightly overweight Australian duration on our view that cyclical downside risks to the Australian economy will keep easing pressure on the RBA, while we hold reduced shorts in both the US (on the basis of the relative cyclical strength of the US economy) and in Germany (against negative yields and where valuations appear worst). Despite the reduced relative-to-benchmark risk involved with our current positioning (compared to our maximum short of 1.80 yrs in the middle of 2015), we are conscious of the greater absolute risk (through both longer duration and lower yields) involved and are attempting to balance that trade-off. This is a difficult task in the current environment.
Our credit positioning has also moderated. We took advantage of narrower spreads in June to reduce our credit exposure. We are now just slightly overweight credit versus benchmark. This is low both relative to the portfolio’s history and in absolute terms. Issuance trends continue to further weight the benchmark towards government issuers (89%) at the expense of corporates (11%). While credit is favoured by a continuation of the low-volatility economic environment and by ongoing central bank market participation (which in addition to encouraging buying of riskier assets also dampens volatility, making carry trades more attractive), we’re cautious about credit owing to concerns about the US credit cycle. With valuations back close to fair value we prefer high quality short tenor bonds. We continue to run a collective underweight position to non-credit assets (i.e semis and supras) given the modest return over government bonds. Meanwhile cash remains a preferred allocation.
With a reduced underweight to duration risk vs benchmark, only moderate credit exposure and high effective cash weight the strategy is well positioned to continue to provide defensive absolute outcomes, albeit that the market-policy dependence may impair short term relative returns.
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