Waiting for the next domino to fall
Bond managers have suffered horribly since the credit crisis started to bite. With liquidity hard to come by and treasuries yielding little, it has been difficult to know where to turn. Such was the unhappy picture until euro zone spreads obligingly began to widen out from German bonds, providing a splendid spread trade opportunity.
Bond traders have also tried to identify suitable macro trades, in order to ride the yield curve down. But generally bond markets look expensive, as government bond yields have fallen so far on the safe haven bid. For example, short term government bonds are giving only a 1 pct yield because they are being used as a place to hide. “The hedge funds who started to pull their collateral from Bear Stearns went into Treasuries because they didn’t want to see that collateral disappear into a bank bankruptcy,” said James Gledhill, head of fixed income at New Star Asset Management.
He doesn’t see this changing in a great hurry. “Government bonds will remain at a premium, but as the banking system stabilises and inflation remains stubbornly high, they will start to look poor value. Inflation is bad for government bonds – some of those commodity price increases are bubble induced, but some of it is permanent.”
Bond managers like Scott Thiel, global co-head of fixed income at BlackRock, and Thomas Kressin, senior vice president, global bonds at Pimco, are particularly frustrated by the continuing lack of liquidity in the fixed income markets, which has made it harder to execute strategies. This liquidity drought relates to continuing market fears over counterparty failures and the downfall of Bear Stearns last week has merely accentuated this. “These days you can’t trust anyone as you don’t know if there will be another bank failure – you don’t know which will be the next domino to fall,” says Kressin.
Thiel adds that bid/offer spreads, and the amounts that are tradeable at particular prices, have all deteriorated much more than he would have anticipated, even in June or July of last year. “That all comes back to balance sheet usage by dealers, and the dearness of government bonds. We are all a bit surprised by how illiquid bond markets have become. If you look at the currency markets, they have remained liquid and I would argue that the stock markets have been. So it’s an interesting development for a market that was once the bastion of liquidity.”
In this environment, Thiel says managers are forced to take a longer term view: “We’re investors, not traders so we have time to put a position on and have it come good. But these conditions make market making very difficult, and for traders relying on short-term price movements, the amount of transaction costs or slippage can sometimes become too onerous. It forces us to look at relationships and transactions and think about them in a more strategic and longer-term way simply because the transaction costs will be higher and the return has to be higher per unit of risk.”
He says that BlackRock is pretty neutral duration in terms of overall exposure right now, but it has some important country allocation trades. For example, Australian government bonds look attractive as the Reserve Bank of Australia has been in tightening mode whilst other central banks have been easing, so rates are high. If global economic growth slows the RBA may have to cut, so these bonds offer value versus US government bonds.
Thiel adds that European government bonds are one of the cheapest markets available as the ECB has been quite hawkish, but it should ease monetary policy as it begins to feel the effects of the US slowdown.
For the US, Sebastian Mackay, senior economist at SWIP, sees a bottoming out towards the end of the year as residential investment eventually finds a floor, but adds: “We think yields are going to be a fair bit higher in 12 months’ time. They’ve been supported by the financial crisis and the bid for safer assets and some of that will unwind over the next year. So we see 10-year yields back up at 450 on a year’s horizon.”
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