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Liontrust's Roberts: 10 potential fixed income trades

As the summer draws to a close, Liontrust's new fixed income boss David Roberts looks at 10 possible fixed income trades.

David Roberts (pictured) joined Liontrust, alongside fellow Kames bond fund manager Phil Milburn, a year ago to set up a fixed income business for the boutique. 

The duo has since launched the Liontrust Strategic Bond fund. In this gallery Roberts runs to the rule over 10 potential bond trades, highlighting his favourite chart and explaining why he is very comfortable not owning gilts. 

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David Roberts (pictured) joined Liontrust, alongside fellow Kames bond fund manager Phil Milburn, a year ago to set up a fixed income business for the boutique. 

The duo has since launched the Liontrust Strategic Bond fund. In this gallery Roberts runs to the rule over 10 potential bond trades, highlighting his favourite chart and explaining why he is very comfortable not owning gilts. 

Leave a comment!

Please sign in or register to comment. It is free to register and only takes a minute or two.

Graph 1: Japanese 10-year bonds – a yield high of 0.1%

A Short position in Japanese Government Bonds (JGB)

JGBs are a major part of the global bond market and indices but I must confess that over my 30 years in the market, I have probably owned them for a total of no more than six months. Incredibly, low yields and market manipulation has made this a difficult area in which to make money.

Recently, however, there has been a suggestion that the Bank of Japan (BoJ) is ready to change its monetary policy stance.

Previously, it 'targeted' a yield of 0.0% (yes, zero) for 10-year sovereign debt. Market chatter and semi-official leaks suggested that at its policy meeting on 31 July, this stance could soften and the yield target move higher. Ahead of that, JGB yields rose from 0.03% to 0.11%.

I was not convinced the BoJ would be so aggressive, given inflation is still only around its target – albeit rising. However, there is an obvious trade to do. The BoJ was more dovish than the market thought and yields moved back from 11 to a mere five basis points. For the first time in a decade, this looks a compelling short if you believe the BoJ has been testing the market and will now allow bonds to move in a 'flexible manner' in line with its new policy statement.

There is almost no cost of carry (if done via futures) and, with all the chatter, it does appear a further softening of policy is only a matter of time.

This is not a get rich quick trade, but over the next few months could add double-digit basis points of cheap alpha.

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Graph 2: Australian sovereign yields have moved back toward the lows (Source: Bloomberg, as at 30.07.18. Chart shows yield in % terms)

Take profit on Australian debt

We have been running a long position in Australia against the US market and, in recent days, this has worked very well. Although the domestic economy is doing okay, the Central Bank is adamant rates will not rise soon. And as the trade war focus switches firmly to the cooling Chinese economy, demand for Australian goods and services looks to be waning.

There is a decent argument to be made for running the Australian position a little longer and in the very short term that may make sense. However, it is often better to travel than arrive with rates journeys, so reducing or closing the position is currently favoured.

Note: a long Aussie Bond position is a soft proxy for short emerging markets. Although I like this position, I’d prefer to take the bet elsewhere.

As the chart above shows, Australian debt is also close to an 18-month low in yields – at a time when the yield on many Western bonds has been rising. It doesn’t look like a disaster to remain long, although the market has struggled to take yields much lower and better value may exist elsewhere.

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Graph 3: The US yield curve has flattened – five-year lows may be worth opposing (Bloomberg, as at 30.07.18. Chart shows yield in basis points) 

What about a US curve steepener?

For nearly three years, I have talked about the overvaluation of short-dated US Treasury bonds compared with long maturities. Back in 2015, I was paid 2% more to own 30-year bonds than five-year. Today, that differential is down to 0.25% and I think this is pretty fair for economic conditions.

Normally, the curve will start to steepen as the Federal Reserve raises rates. However, the pace of recent rate rises has been so gentle it is abnormal. This is a major part of the reason why earnings and equities have moved higher – the Fed has not choked off growth. And then President Trump put $1.5 billion of tax breaks into the economy

However, it does appear the Fed is starting to get a little jumpy and certainly may err on the side of hawkish policy to curb an already hot economy (6% nominal growth in Q2 after a 10-year expansion is unheard of).

If this happens – four rate hikes, possibly five over the next 12 months and not the three that the market expects ­– then this will apply the brake a little more forcefully. Under these circumstances, expect short-dated bonds to do better than long ones. And this is when equity markets should start to worry.

A steeper curve is a sign the Fed is being aggressive, that consumption will slow and that corporate earnings will be hit (it also means the USD goes up a bit, so goodbye emerging market and overseas earnings for the S&P 500).

 

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Graph 4: The excess yield on higher-risk bonds is back to three-month lows – a tactical sell? (Bloomberg, as at 30.07.18. Chart shows yield on the itraxx Euro Crossover Index in basis points) 

Credit (more specifically, controlling the risk)

Our funds have (fortunately) been a little longer credit risk than we wanted. In part, this has been because we found a number of nice new issues at cheap levels.

Our three things to watch for – trade, Italy and QE reduction – are all still live. Yet credit markets, which had struggled during May and June, are now back at year-to-date highs. The smart money is betting on a summer grind and that a lack of supply and bad news (all the politicians are in Tuscany or Provence for a few weeks) will take spreads even better.

That is as may be. However, as I said, there has already been a material recovery and I am keen to have the firepower to add into a risk-off environment. I expect plenty of volatility in the autumn, adding Brexit and the US mid-terms to the list above. 

So for now I intend using the itraxx Crossover Derivative index to take between 5% and 10% risk out of the portfolios.

We do have around 50% in securities rated BBB or lower, so a summer grind will still suit. Of course, if prices move a good way higher during August, we will likely trim more.

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Graph 5: The 'price' of EM debt has fallen relative to high yield – not massive, but enough to pique interest? (Bloomberg, as at 30.07.18. Chart shows current option pricing levels on HY and EMD indices)

Emerging markets – to sell or not to sell

For once, this is a little trickier. As regular investors in my funds will know, I have an anti-emerging market bond bias. I always struggle to understand why people buy bonds in rapidly growing economies: leaving all the liquidity and regulatory issues aside, strong growth and high inflation are normally enemies to the bond investor.

However, despite a recent recovery in absolute terms, emerging market debt has underperformed high yield. This suited my funds but now I am torn.

I see a stronger dollar and possibly heightened US/China trade tensions – especially if Mr Trump thinks he has won the day with Europe. This will not be great for emerging markets, but the value does look a little better.

This, I think, is where I hide behind 'portfolio shape': emerging market and high yield have remained correlated for most of the past 10 years.

We are (as I said above) long risk assets. Although I can make a value case for shorting high yield, if the issue is more about overall portfolio level risk, then selling emerging market indices will also work.

Of course, this is my natural bias but it is also a ticket to the ride should we see an escalation of tensions between the world’s two super powers. And as an aside, I’m also happy to be short Turkey.

 

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Graph 6: My favourite chart – short or long-term investor? (Bloomberg, as at 30.07.18. Chart shows yield spread between US and Canadian 10-year bonds in basis points)

Why do Canadian Bonds pay a lower yield than US ones?

This is not rhetorical – I can’t understand why. For most of the past 40 years, Canadian debt has traded at a discount to that of the world’s leading reserve currency – on average around 0.4% more per year.

In the past couple of years, this relationship has changed, which is a little bit to do with central bank activity, a lot to do with a belief that Canada is a wholly commodity-dependent economy. Today, Canadian debt yields 0.8% less than the US equivalent.

A frightening thought, part one: most of today’s bond managers were not working before the Global Financial Crisis.

A frightening thought, part two: most investors think 10 years in markets is a long time and don’t look at returns or patterns over periods beyond than that.

And when was the GFC? Well, 10 years ago – so if all you do is look at patterns since 2008, you are working with fake data: Central Banks will not always be our friends.

Add the two together and what do you get? A belief that the mad trading patterns we see today are in some way 'normal'.

Over the past 10 years, on average Canada has yielded 0.2% less than America – so, the accepted wisdom is that this is now 'normal'.

Even allowing for this 0.8% of a differential is way too much. Take a proper, pre-financial crisis view, understand that as QE ends we are likely to move back to the 'old normal' and being short Canada just looks about the world’s biggest no brainer. PS: it’s also carry positive.

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Graph 7: What about adding Norway? – France looks expensive (Bloomberg, as at 30.07.18. Chart shows yield spread between Norwegian five-year bonds and French ten-year in basis points)

Norway – listen to the Central Bank please

A couple of months ago, the Norwegian Central Bank decided to bring its inflation target into line with that of most other major economies, reducing the CPI target from 2.5% to 2%.

Strictly speaking, the lower an inflation target, the higher that yields on bonds need to be.

So, it was no surprise when in the short term, bonds fell in value. Once the dust had settled, a five-year Norwegian bond paid a yield more than double that of core European bonds.

Given Norway now has the same inflation target as the European Central Bank (ECB) and (ex a bit of oil) an economy dependent on Europe, adding Norwegian bonds at these cheaper levels and selling anything else European seemed a good idea.

I’ve cheated slightly - the Norway above is only five years maturity, where volatility should be less. However, French 10-year bonds only yield 0.7%, so even this mis-match doubles yield.

As with many of the trades outlined, this is a mean reversion, slow grind profit. We will not come in one day and find we have added 5% to the funds’ value.

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Graph 8: A short-term chart but it highlights the volatilty in a supposed stable relationship (Bloomberg, as at 30.07.18. Chart shows yield spread between French and German ten-year bonds in basis points) 

Hands up if you think France is now 'risk free'?

President Macron seems to be doing a fine job modernising French industrial practice. The market has rewarded him by reducing the yield of French debt almost to that of German.

Of course, it wasn’t that long ago that we worried Marine Le Pen would walk the corridors of the Elysee Palace, and it was only three years ago that the previous Euro crisis had French debt yield much more than German. Even in the latest bout of Italian inspired Euro angst, French bonds fell 3% or 4% relative to Bunds.

Today, we can sell France and buy Germany at levels near all-time tights – we pay about 0.2% a year for this trade. Now, there has to be a chance all things are not well in Rome and Milan come September – I like the odds: I pay 0.2% with a chance of making 3% or 4% should Italian politics prove volatile.

 

 

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Graph 9: Just a reminder: yields are still at emergency levels, while growth and inflation are good (Bloomberg, as at 30.07.18. Chart shows yield on 10-year gilts in % terms) 

Surely Brexit means “be long Gilts”? Surely not.

The maths here are simple. We have had two years of angst and yet the UK economy is running close to a 4% level of nominal GDP growth and inflation is well above target.

A 'good' Brexit result and the economy ticks along, the Central Bank raises rates a couple of times next year and holders of 10-year gilts probably lose around 4% or 5%.

A 'bad' Brexit result, sterling collapses (options suggest around 8%), inflation rises in short order and after six or so months of pain, the economy is going gangbusters (Mr Trump would kill – metaphorically of course – for a dollar 8% weaker).

Unless the Bank of England reintroduces QE quickly, gilts should be in trouble, in part for good reasons.

It may take a little time – March 2019 for example – but I remain very comfortable not owning gilts. I wouldn’t invest in them myself, I wouldn’t invest client money either.

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10. Avoid beta – bond holders are still subsidising equity holders

One thing almost all of the trades above have in common is that they deal with relative value.

Core bond markets today remain near their all-time highs. US assets are a little closer to fair value, but even there, investors are scarcely compensated for inflation, never mind either the real or nominal rate of economic growth.

If your yield is lower than inflation, you lose money in real terms (see Germany, the UK and Japanese bond markets). If your investment yields less than the real rate of growth then your share of the economy is eroded, if lower than nominal growth then you expect to lose wealth compared with those buying other, riskier assets.

Given sovereign debt is supposed to be “risk free” (it isn’t but let’s pretend), then the rational investor wants to retain their store of value (paid at least as much as inflation) and will accept a return a little below the nominal rate of growth – after all, those investing in equities are expected to take more risk, so they should expect a return above the nominal rate.

Taking a liberty, adding the two together kind of gets to the nominal rate. Again, in basic terms, bond investors aim for the real rate of growth, equity investors the nominal rate.

As an example, assume the economy grows at 6% nominally, with 2% inflation and is 50% debt, 50% equity funded. Bond investors should expect to be paid somewhere close to 4% (the real rate of growth), equity investors somewhere above nominal, 6%. In this example, if bond investors receive about 4% then equity investors receive about 8%.

Funnily enough, the US economy is today growing at 6% nominal with 2% inflation. However, bond investors are funding that growth for less than 3% – a direct, potential transfer of wealth to equity investors. Of course, this has been the case for nearly a decade and in part accounts for the record levels we see in many equity markets.

As QE unwinds and yields move higher, those buying bonds will receive a higher level of compensation. Although not quite a zero-sum game, the more paid to bond investors, the less there is for equities – this in part is why equity managers pray bond yields stay low, that QE continues ad infinitum.

So why low beta? Well, the main reason yields have been low is central banks bought a lot of bonds and suppressed yields to stoke up the price of financial assets. This has been great for many but it now leaves bonds looking too expensive and needing to reprice.

A major reason for this need, is that left uncontrolled, this easy money filters through to risk assets inefficiently. Bubbles are created and, similar to 2008, it all ends in tears: $120bn off Facebook anyone?

So bond investors should wait. As we have seen for a year in the US, bond prices are falling, yields rising. There is no need to have a full allocation to bonds today, the chances are that, ex-a big shock, you can get more for your money tomorrow.

Of course, there are plenty of relative value trades to exploit. Indeed, the great advantage for the active bond manager is that rates cycles are messed up at present. Differentials between major markets are extreme – options 1 to 9 above – and there is a high probability these will soon start to normalise. Although beta, the risk of just buying the market, looks expensive, alpha is plentiful and could well provide adequate compensation to those who still need or want a few bonds.

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