Bonderland – Fixed income markets are increasingly resembling something out of Lewis Carroll
Curiouser and curiouser. Flip open any issue of the Financial Times these days and the chances are you will find a number of articles that only add to a general feeling the world of debt is losing touch with reality – that it is turning into something out of Alice in Wonderland (and we leave it to you to choose which characters that puts in charge of global monetary policy).
Take, for example, ECB QE alchemy transforms junk bonds, which points out that, in the eurozone, €1.4 trillion (£1 trillion) of sovereign debt now has negative yields, more than two-thirds of investment-grade debt now yields less than 1% and half of bonds rated BB – the point at which they become less flatteringly known as ‘junk’ – now yield less than 2%.
Picking out a few specifics, Switzerland recently issued a 10-year bond at a negative yield for the first time ever, Germany is a hair away from going negative on 10 years and even Portugal – very much to the fore during the euro crisis – has been able to find investors happy to pay to own its two-year debt. Wow – words almost fail us so instead we will let the following chart from Citi Research sum it all up.
Source: Bloomberg, Citi Research, April 2015
So what on earth is going on? After all, according to the latest Bank of America Merrill Lynch fund manager survey, 84% of those polled – the highest figure on record – believe bonds are overvalued. Well, our first clue can be found in that FT article above, which quotes one professional as saying: “This market distortion represented by QE is a gift from heaven given to investors by the ECB.”
More worryingly, the quote continues: “It is difficult to tell your clients you are not accepting this gift.” If that reminds you of something, it could be the words of former Citigroup boss Chuck Prince, who in 2007 dismissed fears of loose lending standards with the infamous line “as long as the music is playing, you’ve got to get up and dance”. And then the music stopped …
The FT quote is also reminiscent of the late 1990s when many professional investors acknowledged the tech boom was going to end badly but felt they could not afford not to participate – especially if they were able to point to examples of former colleagues who had lost their jobs after choosing to leave the dancefloor while the band was in full swing.
“Unfortunately, doing what is right by your investors is not always consistent with doing what might keep you in your job,” as we noted in a similar context in Your starter for tenure – and, if you care to look, you will find fixed income fund managers going to ever greater lengths to justify the positions they are taking. The current refrain is: “We will go negative duration ... but we will time it.”
One curious aspect about this whole situation is it is not just our metaphorical dancers who feel they have to keep on strutting their stuff – the people who are providing the music, by which of course we mean the policymakers at the world’s major central banks, appear to be finding it tough to lay down their instruments.
The aims behind low or negative rates and other elements of quantitative easing are well-known – to encourage people to save less and spend more, to reduce the cost of corporate debt, to spur growth, to create a ‘wealth effect’ and so on – but how many central banks do you need to have doing the same thing before it becomes consensus or, worse, a herd mentality?
From tulips to tech stocks, so many financial crashes have stemmed from everybody thinking and acting in the same way and here, over the last seven years, we have had the world’s largest central banks rolling out larger and larger programmes of monetary easing. This may not be the precise inverse of investors careering towards the ‘euphoria’ stage of a market bubble but it feels pretty close.
Often in finance, when there is a strong consensus something is correct, it can ultimately prove to be very wrong indeed. What we are seeing now are investors who have forgotten about the risk of rising rates – a significant risk in itself – and who are confusing calm markets with stable ones. In the context of history, one might think only a Mad Hatter or a March Hare would consider negative real yields as an acceptable reward for owning government debt – and yet here we are. Curiouser and curiouser.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
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