Has the bear market in bonds arrived?
Fixed income fund manager Gareth Isaac discusses whether the recent weakness in bond markets is a short-term setback, or the start of a sustained bear market for fixed income.
Is the recent sell-off a sign of things to come?
Recent bond market performance has caused some commentators to call the start of a bear market, but when there are significant market corrections, it is important that investors remind themselves of where markets were before the weakness and why.
Although bonds have indeed sold off, led by fragility in Europe, they have done so from valuations at all-time highs.
Why have bonds become so expensive?
Growth expectations in Europe, at the start of 2015, were extremely low.
The reason that the European Central Bank (ECB) announced its quantitative easing (QE) scheme in January was to reverse this trend of negative macroeconomic data.
Inflation expectations for the region were further weighed down by the persistent oil price falls which began in mid-2014.
Investors, knowing that the ECB would be buying bonds until 2016, were forced further and further along the yield curve; pushed into 10-year, 20-year and 30-year bonds to find a return.
However, the buying support went too far and in April, the 10-year Bund was yielding just 0.07%.
Even with no expectations of economic growth or inflation at all for the very long-term, bond valuations at these levels reflected absolutely no risk that forecasts for economic growth or inflation could be wrong.
Have investors woken up to a rebound in oil and eurozone growth?
However, eurozone growth began to build once more in the first quarter and the oil price regained some ground.
The growth we are seeing now probably has little to do with the ECB’s QE programme.
It is likely, instead, to be the culmination of the ECB’s introduction of negative deposit rates, the Targeted Longer-Term Refinance Operations (TLTROs) and the finalisation of the Asset Quality Review which had kept capital shored up in Europe’s banks.
All of these initiatives were introduced last year, and all were created to free up capital to be spent and invested.
Investors have woken up to the fact that bond prices moved to absurd levels between January and April.
With oil prices now recovering, growth returning and ECB QE set to continue, some of the interest rate and inflation risk has been built back into bond prices during the bond market setback.
Where do markets go from here?
We feel it is important to highlight that we do not believe this is the start of a sustained fixed income bear market.
Interest rates in the US are still effectively zero and are negative in Europe.
Until there are changes to these policy rates, cash is not an alternative for investors. Bonds, even with low yields, are comparatively alluring.
If and when interest rates do start to rise, then the question for investors will be whether bonds are still worth the risks they represent, but not quite yet.
Important information: The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall. Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.