The performance of bonds, particular of long duration, have surprised many this year. Most experts predicted that yields would rise in 2014, but on the contrary they have fallen on the back of macroeconomic concerns, equity market weakness and geo political tensions.
Performance of indices in 2014
Source: FE Analytics
With the threat of further economic woes in the eurozone and the lack of inflation in western markets, many have suggested that interest rates will continue to stay “lower for longer”, therefore justifying record low bond yields.
However Eigen (pictured), manager of the $8.5bn JPM Income Opportunity fund, thinks such an assumption is dangerous, believing many areas of the bond market are about to crash.
“We are getting to a point where it is really dangerous in the bond market. It’s not funny anymore. I look where rates are, I look where economic fundamentals are and I look what central banks have done to these markets and I am the most nervous I have been in my career,” Eigen said.
Ten-year US treasuries currently yield 2.2 per cent, which Eigen says is a signal that the bond market is now “broken.”
He argues that prices no longer reflect economic realities, given that the US economy has grown at around 4.3 per cent over the last two quarters, inflation is hanging around 2 per cent, unemployment is down to 5.7 per cent and quantitative easing has now stopped.
He says that instead of concentrating on economic fundamentals, overly cautious investors view US treasuries are good value – but only because they offer a higher yield than their Japanese and eurozone equivalents.
As a result of such complacency, he is preparing for an all-out crash over the short-term by holding close to 60 per cent of his absolute return fund in cash.
“If the Fed does what it says it is going to do with interest rates, the bond market is going to violently react to that because it’s just not priced for it – that’s my problem,” Eigen explained.
“It wouldn’t be the first time. If you look at the beginning of any Fed cycle, typically the market refuses to price it in until it actually happens and that’s why you had the big blow-out in 1994.”
“That’s what is scary about it. In 1994, Alan Greenspan had been talking about raising rates and people had started to price it in but when it actually happened, people just lost their minds and sold everything.”
Performance of index in 1994
Source: FE Analytics
In 1994, Greenspan’s Fed’s rate rise caused the bond market to fall close to 7 per cent. However, he says that when the central bank pushes up rates next year, it will be far worse for investors.
“I think 1994 was easy because you had 10-year US treasury yields at 7-8 per cent. We had a massive cushion. Now you are talking about yields at just over 2 per cent. If you get yields normalising to just 4 per cent, there is going to be devastation in the fixed income markets, absolute devastation.”
He added: “You will have bond funds down double digits, easy.”
Eigen warns that investors cannot rely on a diversified portfolio of long-only fixed income assets because huge amounts of central bank intervention have distorted investment grade credit, high yield bonds and emerging market debt markets as well.
“The whole concept of fixed income diversification has gone out of the window,” the manager said.
“Margins of safety across all forms of fixed income are about the tightest they have ever been. People are also underestimating the power of correlation. It doesn’t matter where you are in fixed income anymore; everything is highly correlated to the aggregate index.”
“This is completely different from prior cycles where rates were higher and so you had more of a buffer in the market. Now, margins of safety are so narrow and rates are so low, when rates move the wrong way, which is up, everything loses.”
On top of that, and like many of his peers, Eigen says that liquidity within the corporate credit market has fallen to such an extent that many investors won’t be able to sell when rates do start to rise.
“There is no-one to turn to when you want to sell stuff anymore,” he said.
“The thing that should scare everyone is what happened in mid-October when the single most liquid market in the world, US treasuries, got pushed around like a feather. There were 30 basis point swings in the 10 year treasuries in half an hour.”
“Things like this aren’t supposed to happen, but it shows just how much of a knife edge these markets are on.”
Eigen launched his $8.5bn JPM Income Opportunity fund in July 2007.
According to FE Analytics, it has returned 34 per cent over that time including a 1 per cent return in the crash year of 2008.
The fund’s annualised volatility over that time has been 2.66 per cent while its maximum drawdown, which measures how much an investor would lose if they bought and sold at the worst possible time, of just 4.64 per cent.
Performance of fund vs sector since July 2007
Source: FE Analytics
His very low duration exposure, various short positions and his high weighting to the money market has contributed to his fund being slightly down year to date, though he says this doesn’t overly concern him as he fully believes his investors will be protected next year.
“I worry, I really worry. People who know me know that I am very loyal to the investors in this fund. If people like the fund that’s fine, if they don’t that’s fine too. But, one thing I will not do is compromise my principles just to try and look likes other managers,” he said.
“In my mind, people giving me capital are doing it for college funds or for their kids. I can’t lose that money.”
JPM Income Opportunity has an ongoing charges figure (OCF) of 0.55 per cent.
