The performance of government bonds in 2014 so far has surprised many investors as last year’s spike in yields was seen by some as the end of a multi-decade bull market in fixed income assets.
Ten-year gilt yields started the year at close to 3 per cent and have fallen throughout the year.
Thanks to the much anticipated correction in global equity markets and fears over deflation, 10-years currently yield 2.2 per cent.
Performance of indices in 2014
Source: FE Analytics
However, while the outlook for equities still seems uncertain with QE in the US expected to end at the close of the month and macroeconomic headwinds remaining, FE Alpha Manager Marcus Brookes – who heads up the Schroder MM fund range – says investors should not make the mistake of paying up for protection through bonds at these prices.
“We believe that the US and UK treasury markets are extremely expensive,” Brookes (pictured) said.“Both countries have 10-year bonds yielding around 2 per cent, which is far too low given the relative strength of the economies and the likely pathway of interest rates – up.”
“We believe the recent strength is due to safe haven buying whilst equities are weak, but once this theme runs its course perhaps the shock will be how weak these securities will be.”
He added: “Thus the only alternative for us remains cash instead of government bonds.”
Brookes has long been of the view that government bonds are expensive and has preferred to use cash in his portfolios instead.
One of the most extreme examples is with his five crown-rated Schroder MM Diversity Tactical fund, which has 44.8 per cent in the money market.
As FE Trustnet recently highlighted, this exposure to cash has weighed heavily on the fund’s performance this year.
Performance of fund vs sector in 2014
Source: FE Analytics
Nevertheless, the FE Alpha Manager is still reluctant to start dipping into his un-invested capital because not only does he feel that the bond market is massively overpriced, he is concerned that there will be further losses from equities.
Brookes isn’t alone in his dislike for government debt. Bill Eigen, manager of the $10bn JPM Income Opportunity fund, has told FE Trustnet in the past that the treasuries and gilts are overvalued and, following the recent rally, he is even more bearish in his outlook.“Last week was the equivalent of the ‘flash crash’ [in yields] in US treasuries,” Eigen (pictured) said.
“We saw 10-Year treasuries move from 220 to as low as 182 then back to 215 all in one day, which is not a healthy sign. This in combination with poor economic data coming from Europe and fundamental issues weighing on investors created a toxic mix.”
“Running traditional fixed income today is very much about parsing the words of central bankers, whose policies effectively control the markets.”
He added: “But with the Federal Reserve prolonging the day of reckoning by refusing to raise rates despite the decent economy, the ‘follow-the-Fed’ investment strategy won’t work forever.”
Eigen currently holds a hefty 64.9 per cent of his absolute return bond fund in cash and he says bonds cannot offer a total return from their current prices, because volatility is bound to increase and because the bond market is now highly correlated.
Eigen continued: “To survive the volatility that is no doubt ahead in today’s markets, investors need flexible fixed income strategies that opportunistically draw on different sources of fixed income beta, lowly correlated alpha strategies and the systematic use of hedging to diversify sources of return.”
While Eigen’s JPM Income Opportunity fund has returned 34.32 per cent since its launch in February 2008 – including positive gains in the crash year of 2008 – it has struggled this year and is currently down 0.5 per cent.
Performance of fund vs sector since July 2007
Source: FE Analytics
One of the major reasons why bond prices have spiked, apart from the hunt for safe havens following the equity market correction, is due to fears over deflation.
Despite years of ultra-low interest rates and huge amount of central bank liquidity, official consumer price index (CPI) figures show the rate of inflation in the UK has fallen from 1.6 to 1.5 per cent.
Inflation expectations in the US have also been revised down, while deflation seems a real possibility in the eurozone as inflation on the continent as fallen to just 0.3 per cent.
If inflation were to keep falling, then bonds would be an attractive option for investors – even at their current prices – as they provide a real source of income.
While the risk of deflation is weighing heavily on a lot of investors’ minds, Mark Burgess, chief investment officer at Threadneedle, warns against buying into the gilt and treasury market now.“We discussed our investment positioning – as we always do – at our weekly asset allocation meeting and our conclusion was that it made no sense to buy bonds at current levels,” Burgess (pictured) said.
“We also concluded that we would not sell equities, but neither would we add to our current holdings. In our opinion, it is only possible to make a sensible case for buying core government bonds at current yields if you believe that the world will remain in a deflationary environment indefinitely.”
“We do not share that view and recent US data – jobless claims and industrial production – has been encouraging; albeit largely ignored by markets.”
