By Mike Turner, fund manager at Edinburgh Fund Managers Returns in UK fixed interest market over...
By Mike Turner, fund manager at Edinburgh Fund Managers
Returns in UK fixed interest market over the past year have once again proved competitive, outperforming both cash and equities.
This is surprising as the economy has spent most of the year recovering from the downturn of 2001. Indeed, inflation hit a trough back in December at 0.7%, although the underlying rate reached its lowest level in June at 1.5%.
This year's bond market returns have been determined by the performance of the stock market. The volatility in stocks has been replicated in credit markets, with the daily correlation between government bonds and equities at a very high 80%-plus.
Duration positioning has become a game of stock market anticipation. Not only has the relationship between stocks and bonds become more interdependent but the correlation between global bond markets remains high.
This is particularly relevant as yield curve movements within the US Treasury market have become extreme. The most important reasons for this are firstly the decision to eliminate new long bond issuance and secondly the inexorable rise of the mortgage-backed securities market.
The first is self-explanatory but the second is more complex. Mortgage-backed securities have duration profiles that shift markedly with large changes in yield, a concept known as convexity. This is because the pre-payment risks associated with mortgages rises or falls with movements in bond yields.
In order to stabilise their portfolio durations, investors buy or sell US Treasuries in an overlay fashion.
Their preferred maturity for executing these transactions is the 10-year note. The size of the mortgage-backed market is so large (approximately 30% bigger than the US Treasury market) that these convexity trades radically shift the shape of the yield curve.
This phenomenon is also apparent in the corporate world. The recovering economy has done little to reduce risk premiums as confidence in the reliability of financial statements has raised creditworthiness concerns, as has the degree of corporate leverage. It has been a year of avoiding the minefields in corporate bond investing, despite the positive returns of the total market.
Since stock prices can be an indication of the future business environment, their recent fall may blunt the propensity of businesses to invest. But this has largely been priced into the bond market, so where do yields go from here? Central banks have adopted an easing bias, which, in itself, will do little to damage bond returns in the short term.
However, it seems unlikely the bond/equity correlation will subside either. A stable short rate outlook should encourage investors to shift along the yield curve but if equities continue to fall, yield curves will maintain their steep shape as budget deficits grow.
While inflation remains tame, these various factors will influence government yields. In corporate markets, credit risk premiums will be determined by the ability to deleverage rather than an economic recovery.
Banks have adopted easing bias.
Continued stock volatility.
Demand for duration high.
Budget deficits growing.
Corporate leverage a concern.
Investor confidence is low.
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