It has been a challenging year for fixed income investors with a lot of price volatility. This month has seen major sell-off in the asset class as investors weighed up risks posed by strong economic data in the US and the likely impact of further interest rate rises.
Bond funds invested in longer-dated European bonds and high-yield debt, in particular, have taken a hammering this month.
The yield on a 10-year US treasury was at a seven-year high of 3.17% on Tuesday, while Italian government bond yields have been spiking sharply amid fears the Italy’s populist government is set to clash with the European Union over its spending plans.
Rate rise divergence
In September, the US Federal Reserve raised rates another quarter percentage point to 2-2.25%, the eighth rate rise of the current cycle and more rises are widely expected, possibly in December.
However, the Fed’s increasingly tight monetary policy contrasts sharply with the European Central Bank. The ECB has kept interest rates at record low levels – its deposit rate remains at -0.4% – and a rate rise is not expected until at least next summer.
Unlike in the past, the European economy has clearly diverged from its US counterpart.
However, this divergence can create opportunities in fixed income, according to Lucas Strojny, Paris-based head of discretionary mandates at C-Quadrat Asset Management.
“The divergence in monetary policy brings a lot of opportunities, especially arbitrage opportunities between regions,” he said. “We play the spread between European and US bonds.”
“On European bonds, the rates are low but if you buy, for example, futures on German bonds, you benefit from the roll-down effect. The carry seems to be small, but with the roll-down, you benefit from higher performance.”
ECB to remain cautious
While the ECB is expected to begin raising rates in the second half of next year, it’s approach is likely to remain hawkish.
“Ten years after the financial crisis, the overall amount of debt [in Europe] is still very high. Therefore, we cannot expect rates to increase too much otherwise we’ll have another crisis,” Strojny added. “We do not expect rates to rise very much in Europe.”
David Oliphant, an executive director at Columbia Threadneedle Asset Management, said it was hard to imagine interest rate expectations in Europe being any more benign.
“[As a result] we focus our attention on areas that we think we have a higher probability of success by picking the right issue and the right security,” he said.
“Within our macro funds, we see opportunities in being long on US risk, relative to European risk, so our preference is for US over Europe.”
Floating rate notes
EFG Asset Management deputy CEO Steven Urquhart said he expected another five rate hikes in the US “to steepen the yield curve, since each rate hike adds about eight to ten basis points to the long-term curve,” he said.
“Right now, there’s no incentive to go long, because the risk-reward is not better. So, we would tend to look at floating rate notes because, obviously, you’re going to benefit if rates do move up.”
Oliphant added: “The ability to go short, particularly at this stage in the cycle, could be advantageous, adding that in the current uncertain climate encouraged “plain vanilla” bond investments.
“I worry that [the ECB] keeping interest rates in negative territory and continuing to buy assets, even though nominal growth in the eurozone is 3% and we are at a late stage in the cycle is storing up problems,” he said.
Flattening yield curve
Pierre Bismuth, managing director at Paris-based multi-manager Myria Asset Management, shared the view that rates were unlikely to rise much in Europe and fixed income strategies needed to adjust accordingly.
“We don’t see rates rising much,” Bismuth said. “We see a spread of credit, or sovereign credit, rising for certain countries, but we don’t see, to be honest, a rising rate environment.
“Of course, we see the US Federal Reserve raising rates, but the result is a flattening of the yield curve, which is a conundrum for the US side,” he said. “From an asset management perspective, it’s very hard for us to play sovereign curves, either in the US or in Europe.”
Bismuth said that in the current environment his firm liked US high-yield debt “even if it is hedged, because hedging is completely financed by the two-year treasury, so it’s a good carry, but it’s not really a rate risk or duration risk,” he said.
Bismuth added that Myria was not keen on European high-yield because it had been too expensive adding that emerging market high-yield debt might look more attractive after the US mid-term elections in November.
