David Roberts

10 trades for the New Year (revisited after six turbulent months)

David Roberts

It seems a long time ago given the events of the last few months but, at the start of the year, we identified ten possible trades focusing purely on high-quality sovereign debt. Our premise then was that after surprisingly strong returns in 2019 for bond markets, there was less long-term value but still plenty of opportunities for those prepared to look beyond the risk and cost of directional bets.

Revisiting these trades after six difficult months in markets, we are pleased to report that seven of the 10 are positive (and for one ‘opinion’, we claim a score draw). All were based on our long-term process and logic, and designed to work best if things were normal, so have therefore added to returns despite very clear headwinds.

Summary scorecard:

Idea

Has it worked?

1. Avoid too much market direction

No (although it did in places)

2. Don’t fight the Fed – sell Germany into US

Yes (very well)

3. Oiling the wheels – Norway offered cheap AAA protection

Yes (for many reasons)

4. Swiss watching – predicting mean reversion in AAA assets

Yes (but only if you were quick)

5. Apples and Kiwis – buy New Zealand from Australia

Yes (and more than expected)

6. Buy US inflation

No (and it was going so well)

7. Politics matters – gilt volatility post-election

Score draw

8. Buy long German bonds as “protection” v short dated ones

Yes (marginally)

9. Japanese bonds to underperform, switch to US

Yes

10. Oppose QE (higher-yielding G10 bonds)

Yes

 

1. Save money and sleepless nights: avoid too much market direction

Fund position: Lower than normal duration – we have consistently run with duration between 2.5 and 3.0 years, versus our neutral of 4.5 years. We would have made more money being longer but a pure value-based approach suggested a close to zero position. We retained duration as a guard against ‘bad things’ happening. Looking forward, we maintain the current position although it is now investment grade rather than sovereign related.

Has it worked? No. Most government bonds are higher in price than in January. During the first quarter, macro data were looking good and gilt prices did fall but Covid-19 was too strong a tailwind, forcing massive quantitative easing (QE) and pushing prices even higher. Having said this, we resisted the temptation to cut duration aggressively and although we did not maximise the opportunity, our clients did benefit to some extent.

 

2. Donald, don’t fight the Fed: the US central bank is under pressure to cut rates. Relative to all other G7 markets, US bonds remain cheap

Fund position: We had almost all our interest rate risk in the US and that worked well. At time of writing, we have started to temper that – the US is still the cheapest market, just not as cheap as it was, and we now have 67% of duration in the US and 33% in Europe.

Has it worked? Yes. The US had scope to cut rates in response to the virus. Obviously, we didn’t see Covid-19 coming but our core argument was that QE destroyed the ability of risk-free assets to do their job in bad times. Bund investors have struggled to make money this year. Those owning US Treasuries have had it comparatively easy and the reversion towards the mean sees a relative gain of around 6%, from what are supposedly dull sovereign bonds.

 

3. Oil buy some of those: volatility creates opportunities

Fund positioning: We had 10% in Norwegian government bonds and it worked well. We took profits and now have a zero position, recycling the cash into investment grade bonds.

Has it worked? Yes. We owned five-year Norwegian bonds as a cheap AAA hedge against those bad things happening and didn’t really need to know what those would be. As it turned out, the collapse in oil prices meant Norwegian bonds were among the best performers anywhere and they retained liquidity as it collapsed elsewhere.

 

4. Mean reversion: German versus Swiss bonds

Fund position: We were 10% long Swiss, short Germany. Our target was hit and we took around 10bp profit. We will re-examine on any further dislocation.

Has it worked? Yes – for no other reason than prices mean reverted. Markets understood the European Central Bank (ECB) couldn’t cut rates further and so switched back into Swiss bonds to diversify risk. We closed this out pre-virus. It is worth noting that since then, the spread has continued to fall and this is something we may well revisit.

 

5. Compare apples with . . .Kiwi?

Fund position: We were consistently long New Zealand bonds, retaining them as the bottom fell out of all markets in March. Prices recovered to record highs in April and we sold, and also closed out the short in Australia. This worked better than expected and helped materially in fund recovery.

Has it worked? Yes. Again, before the virus struck, New Zealand bonds had started to perform relative to Australian ones. We actually took profits and closed the Australian short, retaining some of the Kiwi long as yields converged. And then Covid-19 and for a week no one would buy NZ bonds – liquidity disappeared from almost all major markets. But when it came back, it did so with a vengeance. Talk of negative rates pushed Kiwi bonds way above previous record highs. We sold, thankfully, and talk of negative rates was at best premature: a lesson for all you gilt bulls?

 

6. Let me give you a TIP: US TIPs look far too cheap

Fund position: We had around 15% in Treasury Inflation Protected Securities (TIPs), which collapsed and then partly recovered. We sold some to manage the risk and switch into even-cheaper core investment grade bonds. However, we retain between 7-10% in these assets that are now on the Federal Reserve’s shopping list.

Has it worked? No. G7 inflation did touch 2% early in Q1 and this looked a banker. However, the economic collapse and energy situation pushed inflation expectations to decade-long lows. Although a core part of US funding, there was no market for TIPs – indeed, this is one of the reasons the Fed acted quickly to launch its bond purchase facilities. We held our nerve and as at mid-June, TIPs bonds are up in price from where we bought and have recovered 67% of their relative performance to conventional US debt. We still own some: oil, after all, is up $70 from its lows.

 

7. Politics… unfortunately it matters

Fund position: We didn’t have one. The market has continued to be very volatile and driven by a host of non- economic factors. A good way to lose sleep and incur fund volatility for little gain.

Has it worked? Score draw. We didn’t really have a view but were unsure whether short or longer-dated gilts offered better value after the December General Election. It has been volatile and although some will have made money from the UK curve, I am glad we stood aside. There are enough reasons to have sleepless nights without taking this kind of risk.

 

8. Back seat driver: German curve doesn’t follow directions

Fund position: We were 20% short five-year German bonds and 10% long 10-year and still have most of that on. While it has been dull, we continue to believe it will give us a degree of protection if we see a second economic shutdown.

Has it worked? Marginally yes. German bonds have been side-lined. With the ECB on hold in terms of interest rates, there has been little reason to move bonds around. This worked because we were short the deeply negative-yielding five-year and long a smaller amount of the less negative-yielding 10-year. Not a stellar contribution, but positive nonetheless.

 

9. Japan has been low beta. Is this changing?

Fund position: We sold Japan into the US: US bonds have rallied, while Japan, as expected, has done nothing. At present, we remain okay in the US but if yields fall below 50bp, we may sell back.

Has it worked? Yes and no. It worked for us in that we feared Japanese yields would move higher so switched back to the US from a previous long Japan position. That proved correct because US bonds rallied in price, not because Japan fell. Still, it made money so we will take that as a positive.



10. QE . . .Early, Quantitative Evil?

Fund position: In late March, we switched almost all we had into core bonds, mainly US and European, weighted to investment grade. Basically, we bought what the Fed and ECB subsequently put in their shopping baskets. We have trimmed exposure slightly but still have over 50% investment grade and 20% high yield, which are our neutral weights. We don’t expect the market panic of March again but would predict renewed summer volatility and a chance to add IG and HY back to levels we hit in April.

Has it worked? Yes – in truth our theme was “buy bonds where QE has done less monetary damage”. This pushed us into the US, New Zealand and Norway and out of Japan and Europe, which worked well. Obviously, we expected 2020 to be a year when rates sold off (and they did). However, the core lessons – QE is dangerous, reduces central bank flexibility and prevents rates from “diversifying” client returns – have been rammed home. We can only hope that, as and when economies return to growth, we end the QE experiment as quickly as possible.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Tuesday, June 30, 2020, 2:55 PM