Liar’s Poker Bond Markets

Any player unaware of the fool in the market probably is the fool in the market.

― Michael Lewis, Liar's Poker

Active fixed-income management may be more relevant than ever in the current environment. Government bond market distortion continues and central banks have no incentive to pull the plug. The situation might end this year; when it does, European bonds are vulnerable to a substantial downside.

Let’s take a closer look at the situation:

Bond investors have had it easy since the 1980s. In addition to income from historically high interest rates, investors enjoyed significant capital gains as rates fell over the years. The chart above shows the 30-plus-year bull market in bonds as interest rates fell after 1982. 

But that bull market is probably over. It likely ended with the double bottom in 2012 and 2016 around 1.5% for the 10-year Treasury. My point here isn't one of gloom. Rather, it's that periods of gains and higher returns will likely be mixed in the coming years with periods of low or negative returns. In such an environment, the passive buy-and-hold approach to fixed-income investing may be less effective and active fixed-income management may be more relevant than ever.

For longer-term bonds, capital gains/losses generally exceed interest income from their coupons in the short term. Long-term bonds lose value when interest rates rise, as they did in the second half of 2016. Tactical management involves shifting exposures to various assets to maximize expected total return or to avoid likely downside (you can read more here on how we at Model Capital approach tactical fixed-income management). The fixed-income universe includes US bonds: short-term, Treasuries, corporates, high-yield bonds, loans, and inflation-indexed. It also includes international developed and emerging market bonds.

Consistent with positive US employment numbers and with inflation rebounding to 2% in recent months, the Fed continued to normalize its short-term policy interest rate by raising rates twice since December 2016. Longer-term interest rates followed and rose above inflation. 

Not so in Europe, where the ECB continues to buy government bonds to keep longer-term rates low. The welcome rebound in inflation to 1% in the Euro zone (and to 2% in the UK) has not yet been followed by any central bank action. It’s becoming increasingly clear that zero interest rates have negative long-term economic effect, eroding traditional savings and investment channels. But the ECB has no incentive to end the program. If it closes the spigot of liquidity, it risks stifling a recovery that's just gaining traction.

Here's a list of 10-year developed government yields around the world:

US Treasuries are considered to be among the safest in the world. So in theory, other sovereign debt should provide a premium for added risk—as do Australian and New Zealand bonds. Not so for most European bonds—they trade at much lower yields (higher prices) due to central bank bond-buying programs. 

To get a sense of Italy's and Spain's sovereign risks, for instance, consider double-digit unemployment rates in these countries:

Yet Italy's 10-year yield, at 2.25%, is below the US (2.36%), followed by Spain’s (1.6%) and other European sovereigns yields, which trade well below 1%. After a recent European Central Bank policy meeting, ECB President Mario Draghi reiterated that the monthly bond-buying program will continue at 60 billion euros per month. Clearly, European officials have no incentive to pull the plug any time soon.

These risk–return distortions created by central banks have now lasted for several years. I want to once again point them out. It's not a question of if they will end, but when. The US Federal Reserve has been normalizing its policy, albeit gradually. It ended its bond purchases in 2014 and has been raising rates since December 2015. 

But the ECB is far behind the curve. With Europe’s economic growth and inflation both picking up, there’s a sense that the ECB might need to taper its bond-purchase program this year. Without the central bank bid, European bonds are vulnerable to a substantial downward price adjustment.

What It Means to Bond Investors

In the context of economic fundamentals and inflation, we think that US interest rates are somewhat low and longer-term bonds are slightly overvalued. European interest rates, on the other hand, are very low, and are poised for a sharp adjustment as soon as the central banks begin tapering their bond-purchase programs—which may happen before the year is over. 

The good news is that few US retail investors invest in European bonds. I think that this market is extremely risky—investors in European bonds increasingly appear to be Michael Lewis’s “fool in the market.”

About the Author

Roman Chuyan, CFA, is the president of Model Capital Management LLC, a Boston-based investment manager focused on asset allocation. Roman founded the firm in 2012 to provide tactical and strategic asset allocation portfolios to help advisors outperform a passive index. The firm’s strategy is powered by a fundamental-factor forecasting approach that Roman developed over the previous decade.

In prior years, Roman held positions with buy-side firms JH Investments (2008–2010), CypressTree (2006–2008), and John Hancock Life Insurance Company (1998–2006). He focused on asset allocation, fixed income, credit markets, and derivatives and developed risk management and valuation models.

Roman holds a master’s degree in finance from Bentley University in Waltham, Massachusetts.