How to play the bond market,
No yield and little liquidity
For t he past f ew years, i nvestors have constantly heard the cry for higher interest rates. The argument was si mple: Global growth is bound to accelerate following the stagnation that spanned the globe since the financial crisis.
This time around, those calls aren’t wildcard, and few experts see meaningful moves higher on policy rates from central banks, at least for the first part of 2016. The U. S. Federal Reserve may be raising interest rates, but other central banks aren’t, paving the way for another difficult year for traditional, longterm bond investors.
That’s not to say there hasn’t been plenty of opportunity for money managers in the fixed- income space, particularly those who have pl ayed t he volatile currency market through sovereign debt. But in Canada, you can’t get a more than one per cent yield in government bonds unless you go out beyond 10 years, and European yields are even lower.
“There is no yield and there is much less liquidity and diversification than there used to be,” said Christine Horoyski, head of fixed income at Aurion Capital Management. “This has been the challenge for fixed income investors for several years and it remains the challenge. The bond market is no longer a market for savers to get good yield.”
Despite healthy employment data, the economic picture in the U. S. is mixed. Couple that with muted inflation, and the Fed’s official policy rate will r emain l ower f or longer.
The bond market is certainly pricing in a very shallow liftoff after nearly a decade without a rate hike from the Fed. It’s also anticipating a very benign pace of rate hikes for the next several years.
“It really depends on the market’s interpreta- tion of economic data in the next couple of months, as opposed to whether t he Fed hikes or not,” Horoyski said.
In t he never- ending search for yield, investment- grade bonds have been a popular destination. But 2015 was a rough year in Canada, primarily because of the large amount of supply coming to the market, mostly from financial issuers. Investors are responding by demanding a higher premium from bank- issued debt stemming from new regulatory capital requirements such as Basel III.
Other sectors such as REITs, retailers and even telcos have also come under pressure on fears that the Canadian economy will soften further, putting pressure on companies’ margins.
Another factor making it difficult for investors to cope is that the federal portion of the Canadian bond market is shrinking, so liquidity issues have become a problem where they weren’t before.
And of course, there is the wild card of central bank action weighing on market behaviour, as even Bank of Canada governor Stephen Poloz has acknowledged the possibility that quantitative easing may need to be pursued if oil remains below US$ 40 per barrel in 2016.
The U. S. treasury market is also coping with liquidity issues. Everyone thinks the U. S. is printing a lot of money, but auction sizes are actually going down. And as the Fed exits QE, a lot of its bonds are maturing.
Martin Roberge , a portfolio strategist at Canaccord Genuity, noted that this shrinking universe has made investment grade bonds in both Canada and the U. S. a proxy for government debt.
Meanwhile, despite signs of improvement in parts of Europe, the European Central Bank is just getting i ts quantitative easing program off the ground, and the Bank of Japan also continues to ease, so meaningful rate hikes don’t appear to be coming anytime soon.
Pan Asian countries have also been impacted by the slowdown in China, which is what has driven Japanese, Australian and New Zealand yields down this year.
At the same time, weak energy prices are putting pressure on economies such as Canada, along with emerging markets such as Malaysia and Indonesia, suggesting central banks will continue to keep rates low there as well.
Roberge noted t hat with the high yield market essentially frozen due to both its high weighting in energy companies and the lack of liquidity, emerging market debt could actually do well in 2016.
“If you are a high- yield manager, you look for liquidity, but you’re not going to find it in Canada,” he said. “You will find it in emerging markets.”
Individual i nvestors and fund managers that have been targeting yield likely got hurt in the high yield market this year. Liquidity risk has proved to be a major factor in this market, along with credit risk, which has long be the focus for investors.
“Investors who chased yield are disappointed because corporate bonds throughout the spectrum have under- performed government bonds,” Horoyski said. “Those that are just buying on yield will probably continue to see lower than historical yields for several years.”
In short, the theme has been one of investors not wanting to take interest rate risk, and favouring shorter- t erm bonds as a result. That’s driven the yields on short- term bonds higher in the U. S., while longer- term bond yields have fallen due to lower growth and dampened i nflation expectations.
But j ust because the Fed raises rates a couple of times, it doesn’t mean yields will return to normal levels in 2016.
Horoyski t hinks t he bond market needs to be approached with a much shorter- term view than investors have in the past. For example, following the sharp sell- off in high yield, Horoyski is adding to positions there for the first time in about 18 months.
“We’re finally getting paid for the credit and liquidity risks,” she said.
Roberge also believes there is plenty of value in the bond market. The problem is few want to get their hands dirty.
“There are good reasons these assets are cheap, but there were also good reasons why Italian, Portuguese and Spanish debt was cheap a f ew years ago,” he said.
Investors who chased yield are disappointed because corporate bonds throughout the spectrum have under-performed government bonds