Fixed income markets, along with other assets, have endured a volatile time so far this year. A major sell-off in credit (corporate bond) markets in the early part was followed by an equally fierce rally afterwards, which, at the time of writing, is still playing out.
For investors looking for a catalyst for this turnaround the European Central Bank (ECB) has garnered a lot of attention; and rightly so. Its landmark decision to buy investment grade bonds issued by non-bank corporations fundamentally altered the perceived demand supply balance in this market and led to an enthusiastic response from the corporate bond market in Europe. Pre dating this announcement, the rally in the oil price from mid February had already provided a huge boost for US credit markets. These have proved particularly sensitive to commodity prices as a result of their generous weightings to the sectors.
Ticking away quietly in the background...
With all eyes firmly fixed in the direction of the ECB and oil, another development was, however, quietly brewing in the background. While yet to receive sufficient mention, the dramatic drop in Japanese government bond (JGB) yields has been a game changer.
Dramatic falls in JGB yields since January
For some time now, the first thing that I look at on my Bloomberg screen every morning has been charts of JGB yields. The 10- and 30-year yields have dropped from 0.27% and 1.28% respectively at the start of the year, to around 0.10% and 0.34% at the time of writing. The catalyst for the collapse in yields was the surprise announcement of negative interest rates in late January from the Bank of Japan (BoJ). Other maturities have also suffered a similar fate; the BoJ's policy of negative rates has certainly succeeded in squeezing out the yield in the world's second largest bond market.
The latest available data from various sources, such as trading desks in big investment banks and also from the US Federal Reserve, the US Treasury and the Ministry of Finance in Japan, paints a picture of Japanese investors disappointed by the negative returns at home and increasingly looking to invest into overseas bond markets, particularly in the US. According to latest research from the Bank of America Merrill Lynch (BAML) and Credit Suisse, Japanese investors have been buying heavily in the US investment grade corporate bond market. Indeed, BAML reports that demand from Japan is so strong that since January a daily US investment grade bond market update sent to clients via e-mail is being translated into Japanese every day.
Global grab for yield
With yields so low in both Europe and Japan, this is fuelling an increasingly global grab for yield that corporate bond managers must navigate. While the relatively unnoticed Japanese purchases of foreign bonds has been a focus on our desk, we believe the need to continue with stimulus in Europe will persist even longer than the Japan led demand. This is because overseas demand is inherently pro cyclical: higher government bond yields domestically would reduce the push to invest elsewhere.
While we have sympathy with this grab for yield trend given the backdrop of low growth, low inflation and low yields, the competition to find attractively valued assets with sensible yields continually challenges us as bond managers.
Inherent dangers in the trend
The skill of a strategic bond fund manager is in determining when the tides are turning and then making the right asset allocation decisions. The current reach for higher yields is well suited to the current low growth, low inflation environment and may continue for many years to come. However, there are tail risks to be wary of, such as a pick up in global growth or inflation that can be detrimental to government and investment grade bond returns. Amid the recent volatility we tried to stay true to our philosophy of investing in 'sensible' yields. In corporate bonds this involves investing in large, non cyclical industrial businesses that should provide our investors with a reliable income stream. In the last year we have generally been adjusting our portfolios, shedding some of the higher risk assets and finding solid opportunities in the US investment grade market. These included long maturity bonds of telecom and tobacco industries with yields of 5% on 30 year bonds and 4% on 10 year bonds. We will continue to seek to navigate these choppy waters with a 'sensible' yield mind set.