While strong returns from bond markets may mean there is less long-term value than a year ago, opportunities can still be found in the high-quality sovereign debt space, according to Liontrust’s global fixed income head David Roberts. 
Below, Roberts (pictured)– who oversees the £355.3m Liontrust Strategic Bond fund alongside Donald Phillips and Philip Milburn – highlights trades for investors “willing to look beyond the risk and cost of directional bets”.
Avoid too much market direction
The first tip for bond investors is to avoid directional bond funds, which Roberts said will have big headwinds – in terms of price and risk – to contend with in 2020.
Taking the UK gilt market as a proxy for global bonds, Roberts said that over the past 25 years yields had come down significantly while inflation had also fallen making real returns for directional investors negative unless there are any further capital gains.
Source: Bloomberg
“This is not impossible, of course, but is increasingly unlikely given how high starting prices are,” he said. “Perhaps concentrating on less directional, arguably less expensive cross market themes may be a way to make money and avoid sleepless nights?”
“Cheap” US Treasuries
While buying German bunds and selling US Treasuries might have made a lot of sense a year ago for investors swapping the bund to dollars for a yield, said Roberts, investors failed to understand that the US bonds were very cheap. And that the Federal Reserve could cut rates.
As US Treasuries were unloved and yields increased above that offered by Bunds, investors failed to understand that the trade could reverse.
“I doubt this will go all the way back to long-run mean levels in 2020,” Roberts said. “That would see a further compression of 1.5 per cent in yields – or put it another way, US bonds returning an extra 15 per cent more than German ones.”
Volatility creates opportunities
“Even closer to home, there are great opportunities to exploit markets,” said the Liontrust Strategic Bond manager. “Everyone seems intent to rush around peering into the darkest of corners to find some way to make money – generally in an illiquid, poorly researched corner of the globe. Frequently, this leaves easy opportunities for those of us who stay behind.”
Looking at German and Norwegian sovereign bonds – “the ‘safest’ instruments money can buy” – Roberts said the trading relationship between the two has been highly volatile thanks to oil prices, trade wars and “bond investor misunderstanding” has created opportunities even here.
“We are told this is a low volatility world: rubbish,” he said. “There is plenty of volatility to take advantage of if you take the time to look. It isn’t particularly difficult, it just takes a little work.”
Mean reversion in German vs Swiss bonds
Despite very different dynamics at work in their economies, spreads between German and Swiss sovereign bonds have collapsed, Roberts said.
While the Swiss economy has continued ticking along, Germany has accepted the burden of supporting “less financially sound euro partners”.
This means that “you can lend to Switzerland today and receive almost the same income as you do lending to Germany”.
“And this has simply not been the case before,” he said. “Buy Swiss bonds, sell German ones and if for any reason this pattern reverses, you’ll be okay.”
Comparing apples with kiwis
While New Zealand and Australia are geographic neighbours the two economies are perceived to be driven by different factors. Looking at trade patterns, GDP or inflation reveals that both countries are “remarkably correlated”, according to Roberts.
However, Australia does more business with China and as the trade war talk has ramped up its bonds have done better than others, including New Zealand’s ‘kiwi’ bonds.
As such the spreads between Australian and New Zealand 10-yr government bonds has recently jumped to a five-year high. Although things could change if the trade war looks like it could be resolved.
US TIPs are too cheap
Another volatile series where Roberts sees opportunities is in the US Treasury Inflation Protected Securities (TIPs) space. The bonds perform better when inflation expectations rise, whereas most normal bonds fall.
More recently, said Roberts, inflation expectations have begun to slide with so-called Japanification taking effect.
“Of course, all the history and forward-looking evidence is that this won’t happen – or at least not for a few decades,” he said. “It is worth noting that over the past 20 years, US CPI has averaged 2.2 per cent and last printed at 1.8 per cent, and this includes the allegedly ‘lost inflation decade’ since the global financial crisis.”
He added: “The point isn’t that inflation linked bonds look cheap or expensive, just that they move around. While everyone else is burying their collective heads in the sand ignoring market direction, this little gem might be a better way to invest.”
Choosing a direction in the UK gilt market
There will be an opportunity in the UK gilt market – where volatility is likely to increase – but Roberts said he is unsure “which direction to choose”.
Until the crisis and the quantitative easing era of low interest rates, long-dated gilts yielded less than short-dated ones. Life and pension funds were regulated to buy long-dated assets and distorting the market.
Source: Bloomberg
However, now the Bank of England’s Monetary Policy Committee seems “unsure” whether to raise, cut or stick with the current rate policy.
“The only certainty is that post the general election, any government looks set to raise public spending,” he said. “This normally isn’t good news for long-dated bonds, but if this encourages the Bank of England to raise interest rates, then short dated bonds could do even worse.”
The spread between German Bunds
Until recently, Liontrust’s Roberts said, the relationship between five- and 10-year German Bunds were negatively correlated with the direction of the market – if bonds went up the spread between them would fall.
This, he said, had been a “great hedge” for the manager in 2019. However, now that yields are lower than they were a year ago, the spread has narrowed.
“I still think there is merit in this trade as a hedge,” Roberts said. However, If you look at our overall fund duration and find it hasn’t changed much in the coming weeks, I’d suggest you need to look at “internals” such as this one to give a real idea of interest rate sensitivity.
“If yields do move a bit higher, then the first thing I’d do is collapse this type of trade rather than add outright duration.”
Japan
Since the introduction of zero interest rates and aggressive forward guidance policy, said the Liontrust global fixed income head, Japanese bonds have been seen as a low-beta play, but that might now be about to change.
Source: Bloomberg
Last year Japanese bonds’ yields were at -0.3 per cent below well below the Bank of Japan’s target range. Now, however, the central bank is arguing that negative rates should only be used with policy tools.
As such, yields have risen by around 20 basis points – slightly behind the strong rise in German and US bonds, “but much closer than it would have been years ago”.
“I’d still bet Japan remains lower beta, especially if the West can find some inflation,” he said. “However, the days of parking money in JGBs and forgetting about them may well be over.”
The end of quantitative easing
Finally, on direction. the Liontrust Strategic Bond manager said that after 30 years of a bond bull market prices remain “incredibly high”.
“Investors who buy and hold have little hope of being compensated for inflation and growth. The final madness began in response to the global financial crisis,” he said.
“What most expected to be temporary or emergency policy measures now appear embedded.”
However, Roberts said it seems that central banks are now beginning to understand this and change tack and that should worry investors who expect to chase direction and look to policymakers for support.