Bond funds being fully invested in traditional fixed income is “absolutely stupid”

William Eigen, who runs the $3.4bn JPM Income Opportunity fund, believes that it is “absolutely stupid” for any bond fund to remain 100 per cent invested.

It is based on this belief that he holds large amounts of cash in his fund. Eigen is currently sitting on 44.4 per cent cash, which is more than double the amount of the portfolio’s next largest allocation (20.8 per cent in high yield bonds).

In a recent investor update, he said: “Don’t be fooled by these managers that a fixed income investor should always be fully invested. I’ve been breaking that rule for 11 years in this fund.

Year-to-date performance of IA fixed income sectors

Source: FE Analytics

“So far this year, cash has essentially beaten every single asset class in fixed income by a lot, with the exception of senior loans and convertibles. And convertibles are more like liabilities on the edge of equities anyway, so I don’t really count those as pure fixed income.”

This rings true in the UK, as the above chart shows cash funds have outperformed every fixed income sector year-to-date and is the only sector to achieve a positive return.

The US Federal Reserve hiked interest rates in March and have forecast two more before the end of this year. Eigen embraced this: “We have virtually no exposure to rising interest rates. We actually benefit from rising interest rates to some degree given our short positions and allocations to shorting rate.”

One thing that befuddled him is why people are piling money into strategies that can only make money when interest rates decrease.

He said: “It’s been so easy to make money in fixed income in the past 10 years because you’ve had the single biggest buyer in history of any market on your side. That buyer is now going away so you have to adjust to it.

“Let’s be clear about this, if you own traditional fixed income, you know, investment grade, government bonds, mortgages et cetera, you are fighting the Fed.”

He continued: “You’re fighting the Fed by owning duration right now and the returns prove it. You’re getting crushed in pretty much everything that’s investment grade fixed income related in the US and its starting to carry over to Europe. Obviously, returns are not quite as bad but pretty much hovering around zero or slightly negative.

“So, I don’t want to own fixed income until I feel like I’m not fighting the Fed and I’m not going to be done fighting the Fed until I think the Fed is done. I think the Fed is nowhere close to being done.”

Money market yields are currently sitting between 1.5 and 2 per cent.

Eigen added: “Given how much money has piled into ETFs and traditional fixed income strategies, I think you still have a technical wave that’s going to come at some point where people realise: ‘Wow, I’m losing a lot of money here, what am I doing in this asset class when I can get 2.36 on 3-month LIBOR? When I can get 2 per cent on a money market fund? Why am I sitting here losing 2 to 5 per cent in fixed income?’

“And you’re going to see a wave of disintermediation from traditional fixed income where all the money’s gone for the last decade into other areas like money market, CDS, not traditional fixed income funds, absolute return fixed income funds and I think that’s coming. And I think that’s going to create technical pressure on rates which is going to send them another leg higher.”

According to Bloomberg, 10-year treasury projections have been off target by almost one per cent on average since the financial crisis.

Speaking about last week’s increase of the 10-year treasury yield to 3 per cent, Eigen said: “The consensus this year was calling for high 2s in treasuries and you’re already at 3”. He went further and suggested that the 10-year treasury yield could “pretty easily” reach 4 per cent and cause big losses for fixed income investors.

US 10-year treasury yield over 1yr

Source: Bloomberg

Eigen said: “At that point, once you get to the 4 to 5 per cent range on a 10-year, I have a funny feeling that you’ll get a technical blow off and people will hate fixing them so much at that point, that it will create bargains for people like me.

“And at that point I’ll ramp up my duration, I’ll buy investment grade corporates, I’ll buy mortgages, I’ll buy even treasuries and maybe even European government bonds.”

However, the bond manager admitted this is not something that would happen in the near future.

“You have to be steadfast about this stuff and you have to ignore the noise and ignore the pundits, which I’ve done for over a decade.”

The flattening of the yield curve does not alter Eigen’s opinion that fixed income markets have been “distorted” by a decade of ultra-loose monetary policy from the world’s central banks.

“The yield curve became so distorted by years and years of Federal Reserve and central bank action that I just don’t think curve shape means the same thing today as it used to 10 to 15 years ago,” he explained.

Last week, the European Central Bank (ECB) maintained its low interest rates.

JPM’s Eigen said: “My opinion is that the ECB is running scared right now. They’re so terrified to reverse policy because of the impact they know it will have that they’re just stonewalling right now.

“That balance sheet is outrageous. If I was a European taxpayer, I’d be freaking out about that. And that balance sheet is loaded with junk bonds at negative yields that were purchased. It’s loaded with lower rated debt. It’s not clean like the US’ was. How they get out of this I have no idea.

“They’re going to have to hit the market with all that cruddy supply they bought of lower rated debt and if you don’t think that’s going to create some technical pressure, I don’t know what will.”

He added: “I’m just waiting because it wouldn’t surprise me at all to see my fund loaded up with European high yield at some point in the next few years because of their desire to get rid of it off their balance sheet and they will be willing to take fire sale prices for it.

“That’s not the consensus opinion but then again, I hardly ever have consensus opinion in this fund.”

He insisted that the only way to get out of this would be for the economies in Europe to plummet and said: “If that’s what you’re praying for to get you out of that, then I hope you don’t own any equities. I hope you don’t own anything to do with anything outside of cash and whatever remaining fixed income you have.”

The fund manager added: “I will stick with cash until such time as the opportunity changes in such a way or I can see forward returns exceeding cash in other areas of the market.”

Performance of JPM Income Opportunity vs sector over 1yr

Source: FE Analytics

It is clear that Eigen values liquidity in his fund: “Cash is liquid. It’s a liquidity hedge. I don’t have to sell stuff to buy stuff when the opportunity set changes when I’m holding cash. Why would I want to hold a 10-year treasury at 2 plus per cent when I can get almost 2 per cent on cash with no risk and have a liquidity hedge in place at the same time?”

Although he does own around 20 per cent high yield fixed income in his fund, Eigen explained it was lower grade, mainly B- and below, where there is some spread so it can benefit from economic growth.

“We have to be patient and wait for our opportunities. I will not own asset classes like this in size when I’m not getting paid to do so.”