Portfolio Manager John Fujiwara and Research Analyst Lucy Holden discuss how low yields and volatile markets reinforce the risk premium commanded to provide bond market liquidity.
Markets have had much to digest in recent weeks: an escalating trade war, slowing global growth and a rate cut by the US Federal Reserve. Potentially overlooked was the late-July budget deal that allows the US government to increase spending by $320 billion. The expansion comes at a time when the federal budget deficit is already on the rise. It is expected to reach 4.4% of GDP this year and 5% by 2021. To finance this, federal borrowing is forecast to increase, continuing a trend that saw net Treasuries issuance crest US$1 trillion last year.
Exhibit 1: Net new US Treasuries issuance
Source: SIFMA, as of 31 December 2018.
While many fret about the long-term implications of budget deficits, the consistency with which the government has had to tap markets reinforces the tendency of bond prices to move in a relatively predictable manner prior to Treasury auctions. The persistence of bond yields rising in advance of an auction, only to reverse within a short period, allows us to categorise this trend as a risk premium that can be harvested with the potential to generate consistent, uncorrelated excess return over the long term.
Exhibit 2: US budget deficit in dollars and as a percentage of GDP
Source: Bloomberg, as of 13 August 2019. 2019 data are projected.
In order to prepare the market for new issuance, the Department of Treasury provides a schedule of maturities and amount that will be auctioned. Primary dealers act as intermediaries with the broader market; it is their role to identify the price investors are willing to pay for the new bonds. It is here that the first tendency emerges; a day prior to an auction – as primary dealers 'seek a bid' on the new issuance – the yield on bonds with maturities close to those to be auctioned tend to rise.
This is likely the result of investors demanding a concession in price in order to absorb increased supply. This tendency seems to be amplified in low rate environments as investors fret about the asymmetric risk profile of richly priced bonds. As the auction process runs its course, prices have historically tended to recover and resumed reflecting investor views on economic growth, inflation and other factors rather than being influenced by a market mechanism.
A matter of duration
Bond prices can also be persistently influenced by other types of investor behaviour. One is duration matching. As the duration of a bond portfolio decreases with the passage of time, investors must constantly purchase bonds with durations longer than those within their portfolio to maintain a steady level of interest rate risk. Consequently, toward the end of every month, the spike in demand for bonds aimed to replace those in a portfolio whose durations have shortened can result in slight price increases. The consistency with which the market commands a higher price during periods of duration adjustment, in our view, is another example of the risk premium paid for providing bond market liquidity. While this phenomenon occurs every month on the open market, Treasury auctions can provide a convenient platform to execute this adjustment. As such, month-end auctions can experience a more pronounced rise in bond prices after the initial concession is identified.
Harvesting the risk premium
As with other risk premia, investors can capitalise upon these temporary price dislocations with the aim of generating excess returns. By using bond futures, there are opportunities to 'short' bond prices a day prior to a Treasuries auction. This positioning is aimed at benefiting from the slide in bond prices as primary dealers probe the market for an appropriate price level. During the auction, these short positions are closed and, later, a 'long' position is initiated, which has the potential to generate additional return as bond prices recover. Ultimately, the duration impact of the two positions cancels each other out. This lack of directionality means the fixed income liquidity risk premium tends to be uncorrelated to bond prices, thus – and as with other risk premia – provides investors with a potential source of uncorrelated excess returns.
The paradox of low rates
Low rates pose many challenges to investors. We believe, however, that the current low-yield environment magnifies the strength of this risk premium as investors are more likely to demand a sufficient concession. It isonly fitting that the low yields that constrain many investment objectives, themselves can augment an opportunity to harvest excess returns. Similarly, the volatility that has recently roiled bond prices, in our view, also reinforces this strategy as uncertainty merits a greater price incentive to get bond investors off the sidelines.
Time will tell
It remains to be seen what the long-term implications of budget deficits are. Yet their presence – and the bond auctions required to fund them – are likely here for the foreseeable future. With rates low and markets volatile, investors may need to expand their toolkit to reach return objectives. As such, incorporating the fixed income liquidity risk premium into an alternatives investment strategy may merit consideration.