As the US continues to show signs of a return to economic stability, the issue that’s worrying investors is what will happen to government bonds if Bernanke rethinks his QE programme
A flood of bond investors walked away from May bruised and battered as concern over the Federal Reserve easing back on its stimulus measures took hold.
Last month Fed chairman Ben Bernanke noted that quantitative easing, his mass bond buying programme, could be tapered back if the US continued to show further signs of a return to economic stability. The remark injected a wave of fear into markets and turned May into the worst month for 10-year treasuries for some two-and-a-half years.
As prices slid back, yields on the US government bonds surged from 1.6 per cent, at the start of the month to 2.1 per cent on the last day. And no-one appeared to be immune, Bill Gross, manager of the world’s largest bond portfolio; the $293bn Pimco Total Return fund, witnessed his vehicle lose almost 2 per cent over the period.
While the S&P 500 has enjoyed new highs spurred on by better economic news, notably in the housing sector and employment, investor eyes are moving to bonds, which have been the subject of bearish talk recently. Speaking to CNBC at the start of May, after the US learned that the rate of unemployment dropped to a four-year low in April, Berkshire Hathaway boss Warren Buffett said he believed bonds “are terrible investments now”, suggesting that many people could lose a lot of money perticularly if they are in long-term bonds.
The issue playing on investors’ minds is what will happen when Bernanke decides to pull back the cushion of QE?
Mark Burgess, chief investment officer at Threadneedle Investments, sums it up, he says: “Whilst we do not expect short term interest rates to rise anytime soon, were growth to pick up and QE to be withdrawn or reduced, there is no doubt that the yield curve would steepen materially from here. The recent bond sell off is probably the first indication of how markets might respond to this environment.”
James de Bunsen, manager of the multi-asset Henderson Income & Growth fund, is more bearish than he has been in a long time on government bonds. He says: “Valuations have been looking very expensive and the US has had some positive growth data coming through, which implies that we could be nearing an end to QE. The issue is who will buy these bonds when the Fed stops? This gives us concern over a managed exit, from the stimulus measures, when they are taken away or reduced.”
Given the positive numbers feeding through, a bullish sentiment is growing among some. Amna Asaf, an economist at Capital economics, points out that the decline in the ISM manufacturing index to a near four-year low of 49.0 in May, from 50.7, suggests that weak global conditions are weighing on US producers.
However he adds: “While the manufacturing sector is suffering, however, other sectors of the economy, particularly housing, are strengthening. The risks of a recession are low. Indeed, we expect GDP growth to pick up in the second half of this year.”
Looking at the fixed interest sector overall, Mark Wright, manager of the multi-asset CF Miton Diversified Growth fund, says: “We have been reducing our fixed income exposure recently, since the start of the year, it has gone down from about 22 per cent to 18 per cent.
“We have been fully aware that there was a lot of downside should yields rise. As a result, we have been decreasing the duration of our funds and introduced strategies more immune to a rise in yields. For example, we use the TwentyFour Asset Management Income fund, which aims for a net total return of 7 to 10 per cent. It is mostly made up of residential mortgage backed securities, so duration is not an issue.”
Multi-Manager analyst at Standard Life Investments, Jason Day says bonds overall year-to-date have generally been performing reasonably well. He notes the equity market rally in the US, however being primarily driven by healthcare, utilities and consumer staples.
He says: “People have been seeking out those ‘bond-like’ equities, those that can pay a regular dividend. This might accelerate as over May 10-Year US Treasuries had their biggest monthly sell off for over two years, which suggests long bonds have a highly asymmetric pay off in that there is very little potential capital upside, and a lot of downside. For that reason, having had a strong run in sovereigns we dramatically reduced duration in the fourth quarter of last year via a blend of dedicated short duration vehicles”.