Volatility... down but not out?

21/03/2019

Download

The Global Bonds team at Janus Henderson reflects on the decline in volatility and how asymmetry in market pricing could present opportunities.


So far, 2019 has seen a big rebound in risk assets with the weakness seen in Q4 a distant memory. The S&P 500 Index recorded its best January start to the year since 1987, and by 5 February the US high yield sector had recovered all of its Q4 2018 underperformance.

Chief among the reasons for the bounce in sentiment has been central banks, particularly the US Federal Reserve (Fed) and more recently the European Central Bank (ECB). With regard to the Fed, we have been in the camp that believes that they tend to overpromise and under deliver, so after the pivot to a more dovish stance in January, we take this to mean they are now going to be patient and flexible going forward. 

As the market has moved to price in a Fed on hold, this has some important implications for portfolio positioning. We continue to expect the US yield curve to steepen as a result of the Fed easing off the pedal for future rate hikes, and the potential for pricing in future rate cuts, most likely in 2020.  Moreover, while the pivot has helped to calm investor nerves, it has crushed volatility, and this also presents an opportunity.
 
The charts below show implied volatility on 10-year US rates (Figure 1) and the implied volatility on the US dollar as measured by the EUR/USD cross rate (Figure 2). The former is at historical lows over the last 14 years according to Bloomberg data. 
 
How can this be explained? While some might say it could be justified by the very tight actual trading range of US 10-year Treasuries in February (just 9 basis points) and a Fed “on-hold”, it is a stretch to assume this can continue indefinitely. In addition, towards the end of Q4 2018 there was significant buying in Treasury options, which are only now being unwound exerting further downward pressure as shown in Figure 1 below.
 
Figure 1: US 10-year swaps – 12-month option implied volatility
1
Source: Bloomberg, 31 May 2005 to 13 March 2019, USD Swaption ATM NVOL 3-month 1year x 10 year
 
Figure 2: EUR/USD – 3-month option implied volatility
2
Source: Bloomberg, 14 March 2001 to 14 March 2019, EUR/USD 3-month ATM implied volatility

Our investment approach looks for asymmetry in pricing in global bond markets. We have sought to capture this in portfolios by buying options (for example on 10 year US rates) to the upside and downside, in expectation of a breakout over the next year. Given this entails paying a premium on both sides we set the bar relatively high for this type of trade, but believe this is justified by the current extreme levels of valuation. More subtly, this type of position is negatively correlated to some of the other risk positions in our portfolios, such as credit, providing broader diversification.
 
Within credit, we still see pockets of value but overall market valuations are now back towards their spread tights, especially in the US. We believe that the Fed is done with their hiking campaign and will move to a more balanced approach, which has led us to increase our level of duration (both in the US and globally) in 2019.
 

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

For promotional purposes.

Anything non-factual in nature is an opinion of the author(s), and opinions are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its us.


Important information

Please read the following important information regarding funds related to this article.

Janus Henderson Horizon Total Return Bond Fund

Specific risks

  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • The value of a bond or money market instrument may fall if the financial health of the issuer weakens, or the market believes it may weaken. This risk is greater the lower the credit quality of the bond.
  • Emerging markets are less established and more prone to political events than developed markets. This can mean both higher volatility and a greater risk of loss to the Fund than investing in more developed markets.
  • Changes in currency exchange rates may cause the value of your investment and any income from it to rise or fall.
  • If the Fund or a specific share class of the Fund seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Any security could become hard to value or to sell at a desired time and price, increasing the risk of investment losses.
  • Callable debt securities (securities whose issuers have the right to pay off the security’s principal before the maturity date), such as ABS or MBS, can be impacted from prepayment or extension of maturity. The value of your investment may fall as a result.

Risk rating

Share

Important message