Though the large majority of experts said that the poor performance of fixed income funds last year signaled the end of a multi-decade long rally in the asset class, bond yields have fallen in 2014.
Performance of indices in 2014
Source: FE Analytics
However Eigen, manager of the $10.5bn JPM Income Opportunity fund, says the recent short-term rally in bonds is nothing more than a false-dawn as there are a number of reasons why prices should fall considerably from here.
“Surprisingly strong fixed income markets have made investors complacent towards risk,” Eigen (pictured) said.“This is a mistake. It is short sighted to believe that rates will inevitably remain low and investors need to be seeking diversification from traditional fixed income.”
The manager says several factors have supported the bond market this year, such as geo-political tensions, continuingly accommodative monetary policy and worse than expected GDP figures in the US due to poor weather.
However, Eigen warns that these issues are only temporary and will only keep a lid on yields for so long; especially as the US economy is growing once again.
“The stronger than expected rebound highlights just how distorted the first quarter figures were by one-off events. Short-term interest rates have already drifted higher reflecting the potential Fed tightening next year,” he said.
“To illustrate how precarious betting on rates is, at current levels, even an increase of just 14 bps in the 10-year yield or 7 bps in the 30-year yield would wipe out the coupon income earned in the second half of this year and cause principal loss.”
“Consider that the last time the Fed alluded to changing macroeconomic policy [in May 2013], long-term rates rose by over 100 bps. Investors saw how losses can be magnified when rates rise and the offsetting income is small.”
Performance of indices in 2013
Source: FE Analytics
Eigen’s biggest concern is that the current conventional wisdom surrounding bonds is wrong.
He says bond-bulls have given several explanations why yields on US treasuries and UK gilts will remain lower for longer; most of which are myth rather than reality.
The first myth surrounding bonds, according to Eigen, is that as the Fed is committed to keeping interest rates low, market volatility muted, and risk assets attractive, so investors can expect several more years of accommodative monetary policy.
“While the Fed can be committed in the short term, the economy may force its hand,” the manager said.
“The labor market has improved markedly over the last few months, inflation has drifted higher and the economy is poised for stronger growth. The Fed is still implementing credit-crisis-like policy, while the pattern of moderate economic growth suggests that it may be superfluous.”
“Ultra-low rates for the last six years and massive amounts of quantitative easing will need to be unwound. As growth becomes more consistent, the Fed may be forced to tighten quicker than anticipated.”
Eigen says that other myths that are that treasury yields will only rise when other regions around the world strengthen and that lower issuance – as result of a shrinking deficit – tied in with strong demand from overseas, will keep a lid on rising rates.
On the first point, Eigen says current yields don’t reflect moderate economic growth and higher inflation is expected in the second half of 2014, meaning that they are trading on a discount to what real yields should be.
In terms of shrinking US deficit and increased demand for treasuries from foreign investors and pension funds, Eigen says there still won’t be enough buyers to pick up the slack when the Fed eventually stops buying up the market via QE.
The final “myth” is that due to weaker global economic growth and changing demographics, investors can be less concerned about interest rate risk, as future growth expectations will be subdued.
“Even when armed with data, investors have a history of undershooting fed funds rate changes,” Eigen said.
“In the last Fed tightening cycle, the market’s expectations of the timing and magnitude of Fed funds rate changes fell short.”
“We believe this same dynamic is occurring again today.” He added: “The Fed has stated a target of a 2.5 per cent for the fed funds rate by the end of 2016 while the market’s priced-in expectation is 1.75 per cent.”
Eigen launched his $10.5bn JPM Income Opportunity fund in September 2007.
According to FE Analytics, the absolute return fund – which sits in the offshore universe – has returned close to 60 per cent over that time, including a 32 per cent return in the crash year of 2008.
Performance of fund since Sep 2007
Source: FE Analytics
Given his outlook for bonds, Eigen is keeping a very defensive portfolio.
He told FE Trustnet last year that he would only invest his 56 per cent cash weighting when there was “blood on the streets” and, 10 months on, that weighting has gone up to 65 per cent.
Several high profile managers agree with Eigen, such as FE Alpha Manager David Coombs who recently said that investors who are buying bonds now will live to regret it in five years’ time.
However Anthony Doyle, investment director at M&G, disagrees with the Eigen’s view on traditional fixed income assets.
He says that high levels of leverage in the financial system and on government balance sheets, structural deflationary forces and a “global savings glut” will all contribute to rates staying lower for longer.
“It appears that the question of where yields move from current levels is more complex than first meets the eye,” Doyle (pictured) said.“This reflects the uncertain and experimental nature of unconventional monetary policy such as QE programmes. Given this uncertainty, it is a useful exercise to question the market consensus that yields must rise.”
“It is very much possible that those looking for yields to rise back to pre-crisis levels when QE ends may be disappointed.”
Despite those points, Eigen says investors would be wrong to not factor in the potential for rising bonds when building their portfolios as bond markets are likely to act very differently over the coming years than they have done in the past.
“While the macroeconomic environment remains difficult to navigate, it is important not to lose sight of why investors hold fixed income in the first place; to protect capital, to lower volatility, and to diversify other risks in overall portfolios,” Eigen said.
“Traditional fixed income has done well given the unexpectedly benign rate environment this year. Should the rally from the first half of the year prove to be unsustainable, however, those gains may prove exceptionally transient.”
He added: “Fixed income investors should ensure that their portfolios are sufficiently diversified and not lose sight of the fact that fundamentals are likely to win in the end.”
