February 14, 2022
The great bond bear market is long overdue
Every month or so we contribute something on markets to our friends at the Australian Financial Review. Given it is behind a paywall, many of our readers – and especially those outside of Australia – will not see these articles – although they will certainly be familiar with the arguments – so we post them here as well. (The links embedded are to other articles on AFR, some of which are ours, some not, which may still be behind paywall.)
Feb 13, 2022 – 10.10am
With the US 10-year bond yield briefly breaking up through the 2 per cent level last week, it’s worth noting that global bond markets in general just completed an absolutely terrible month for performance in January, following on from an equally terrible year in 2021.
Indeed, last year saw the worst annual performance since 1999. However, this is not simply because concerns are rising about inflation – although this is of course a factor – far more important, in our view, is that the annual loss in 2021 has triggered a long overdue global reassessment of the whole point of owning bonds in an investment portfolio.
In Australia, thanks to the wonder of the dividend credits, most savers have little exposure to low yielding bonds, but for most of the pensioners in the rest of the world, so-called prudent regulation means they are heavily exposed to assets with a negative real (in some cases a negative nominal) yield, and are dependent on capital gains for their returns.
Now that disinflation is over, we don’t even have to debate whether the inflation is temporary or permanent, and since the Fed is no longer either lowering short rates or buying the bonds themselves, the question for long-term investors as opposed to traders has to be, ‘why own any bonds at all?’
Driven by risk management, enormous amounts of leverage have gone into bond markets in recent years on the basis they are ‘low risk’, or even, to abuse the terminology from the Capital Asset Pricing Model, ‘risk free’.
With central banks essentially offering (almost) free money, the whole bond complex has become a giant carry trade of borrowing short and lending long. Deflation, or disinflation, were the key economic justifications for continuing to ‘invest’ in bonds yielding close to zero but, in reality, the real driver was that the central banks were buying at any price.
This is why the bond markets are so obsessed with the Fed, not because it has any insight into inflation or economic growth or any of the so-called fundamentals (although it may) but because it sets the price and availability of leverage. An end to ever lower rates and an end to central banks buying bonds means an end to the carry trade and thus a need to deleverage positions.
If a reassessment of the disappearing virtues of bonds were behind the weakness in 2021, something else has started to happen this year, which is that volatility in bond markets has started to rise sharply.
This then creates some second-order problems on the basis that there is a whole complex of what are known as risk-parity quant funds that essentially own a balance of bonds and equities, with a target level of volatility and, usually, a significant amount of leverage – particularly on the bond side.
Rising volatility means they reduce their overall leverage and in this case it means sell the bonds, which go down more. Given the leverage elsewhere in the system, this creates more selling, and so on. This part isn’t new, it has happened periodically during the long bond bull market.
What is new, however, is that this time there doesn’t appear to be any long-term investor ready to buy the dip. Indeed, they appear to be selling the rallies. For us, that is about as simple a definition of a bear market as there is.
As traders flee leveraged bond positions and long-term investors choose to sell into strength or stay away entirely, the medium-term asset allocators are busy putting on the reflation trade that they started this time a year ago, but with a particular emphasis on energy.
A dash for liquidity in leveraged bets in mid-cap tech and crypto at year-end had triggered something of a crash, but also an ‘upward crash’ in megacap tech as a flight to safety. This left many funds with an unhealthy concentration in a small number of big US tech stocks, which they sold or reduced to facilitate a move into energy and other cyclicals.
This in turn has facilitated the inflation narrative used to justify the move in bond markets, albeit it was really about the deleveraging.
Thus we have an end to disinflation, which in turn means an end to QE and the start of a deleveraging programme. Old debt may well be inflated away, but new debt will cost a lot more, which will undermine a lot of the business models that have thrived in the last decade.
Cashflow and exposure to emerging growth opportunities should be the focus of long-term savings portfolios, with a recognition that bonds are now for trading, not owning.
Although they don’t benefit from the imputation credit like the lucky Australian savers, the rest of the world is shifting to an Aussie self invested super-style of saving. About time too.
Mark Tinker is chief investment officer of Toscafund Hong Kong and the founder of Market Thinking. He blogs on behavioural finance and markets at Market-thinking.com.