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Investment analysis: Are we seeing a strange new world for the bond market?

The combination of low inflation growth and excess liquidity following the ECB’s quantitative easing programme has distorted bond valuations, with some short-duration instruments now offering negative returns.

At the beginning of March nearly $3.85trn (£2.56trn) or 17 per cent of developed market global government bonds traded at negative yields, according to Columbia Threadneedle Investments.

In Germany, investors must extend beyond a seven-year mat-urity bond to receive a positive yield while in Switzerland only bonds with durations of 12 years or more escape sub-zero yields.

Columbia Threadneedle Investments global head of fixed income Jim Cielinski says the root cause of this repricing stems from the excess of debt that built up in the wake of the financial crisis.

“This created a very unusual marketplace today,” he says.

Though he is seeing higher credit creation in Europe, in the meantime central banks are not “taking their foot off the accelerator”.

“I don’t really see this changing any time in the next year, at least in the eurozone,”  says  Cielinski .

JP Morgan Global Bond Opportunities fund manager Nick Gartside thinks European yields will continue their downward trajectory because of the supply and demand imbalances created by quantitative easing.

In addition to core bond yields testing the zero bound, he expects to see negative yield potentially spreading to riskier assets. 

He says: “European peripheral sovereign bond spreads could grind tighter and bring in yields by as much as 50 basis points, putting, for example, yield on Spanish and Italian debt at around 75 basis points by later this year.”

Cielinski adds: “Buying bonds at negative rates is a guarantee of losing money in nominal terms. Market participants are accustomed to the possibility of losing money. Certainty of losing money, however, is another matter. This is a strange, new world.”

Hargreaves Lansdown senior analyst Laith Khalaf says: “The fact you have to pay governments for the  privilege of lending money to them highlights the topsy-turvy world created by QE.

“Bond yields at these levels only make sense if you beleive we are in for a serious bout of deflation, otherwise they are just plain crazy.”

bondsgraph

Kames Capital head of fixed inc-ome David Roberts agrees the trade looks far too risky.

“What we are seeing is a potentially dangerous cocktail for bunds brewing in Europe and investors need to be aware of this.”

With yields so low on bunds in particular, Roberts says any move down from current levels should be used as an opportunity to take profits and close out any exposure.

Old Mutual Voyager Strategic Bond fund manager Anthony Gillham is also concerned about valuations, especially in the US.

He says despite “decent” employment data coming out of the US,  bond yields continue to fall. 

“What’s confusing the market is the oil price. That seems to suck gilt yields and developed market bond yields down with it.”

Gillham thinks the bond market has failed to recognise falling oil pri-ces are a temporary phenomenon.

“Bond yields are already very low and the risk is the bond yield gap will be higher in the developed market, particularly the US and UK.”

However, fund managers have alt-ernative options to sovereign bonds.

Gillham urges investors to focus on asset classes where there is a “margin of safety”.

He says the best example is local currency emerging market debt, where yields are above 6 per cent.

In a more negative real rates environment corporate bonds also create an easier environment for borrowers, Cielinski suggests. 

Like many of his peers, Gartside believes longer dated bonds in Spain and Italy offer good value.

Roberts adds: “While the ECB is happy to purchase bonds for now, if the nascent signs of structural reform in Spain, Portugal and Italy gain traction and help the economy recover, Draghi will stop buying and yields will blow out to more realistic levels.”

However, Gillham says peripheral bonds like these do not offer enough value for investors. He says: “Peripheral government debt in terms of its credit spread to bunds offers about the same compensation now as global grade corporate bonds.

“I don’t think that’s necessarily enough and in the event Greece leaves the eurozone, that will cause the market to reassess whether that’s enough risk premium. I don’t think the market is priced for that eventuality, just like I don’t think US and UK government bond markets are priced for the first rate hike which is coming down the track from the Federal Reserve.”

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