Things ain't what they used to be......Bonds now riskier than stocks ?

Monday 3rd August 2015

Things ain't what they used to be......Bonds now riskier than stocks ?

see "Hidden Bond-Fund Dangers Make Stocks Look Relatively Stable" , by Alexandra Scaggs and Liz McCormick,  Bloomberg Business Online

This is the kind of realisation that would have had old-time dealers spluttering into their lunchtime gin and tonics. Historically, returns on bond funds have been far less prone to sudden swings than their equity market equivalents which is of course why long-term sovereign and high quality corporate debt has long been the preferred investment vehicle for the likes of pension funds and insurers. But now, according to Morningstar Inc., bond market volatility is undermining the traditional assumption that bond funds offer the more stable, safer returns.

All markets have had to deal with a host of issues this year : the prospect of higher rates, Greece, China's stock market rout to name but a few. But the volatility in bond markets has far outweighed that of equities. We've often talked about how the high regulatory costs and the more risk-averse environment has led to many of the market-makers (banks) to pull out of bond markets, leading to a dangerous lack of depth in liquidity that allows things like flash-crashes to occur. But there is an even more fundamental issue at play here.

 In the past, much higher yields in bond markets shielded investors from swings in prices by providing a steady stream of interest payments. In the current era of ultra-low yields, even modest adverse moves in prices can wipe out returns, or indeed inflict even worse damage on investors. In that kind of environment, sitting on long bonds no longer seems such a secure strategy.

The authors also point out that the increasing use of highly-leveraged derivatives is adding to the risk of owning bonds. As we know, these can multiply rewards but also have the same effect on losses, particularly when adverse moves in markets prompt traders to dump positions in order to pay margin calls.

One might reasonably ask : If rates are going up, won't higher yields negate the problem of returns being wiped out by price swings ? The naysayers answer to that would come in two parts : Firstly, even if the Fed has been equivocal about the timing of the first rise, there's one thing it has been absolutely clear about : the course of rate rises will be gradual. With continuing mixed economic data, there are certainly no guarantees about the pace and extent of the rises. And secondly, if you take the view that the yield-curve is likely to flatten (as many do), rises in yields in the front end will not be mirrored in the longer maturities.

No relief there, then.

 NOTE : Mixed data makes the picture no clearer......

It seems almost obligatory that one piece of data will contradict the previous one. Friday's release of US quarter-on-quarter Employment Cost Index was a rise of just +0.2%, against expectations of +0.6%. Such a modest number doesn't seem to fit too well into a picture of burgeoning wage pressures demanding a rate hike in September, but it may be forgotten about by the end of the week.

Friday sees the release of US July Non-Farm Payrolls (consensus estimate +220,000) , Unemployment rate (consensus 5.3%) and Average Hourly Earnings (consensus +0.2%). These numbers are more significant, but don't bank on them being decisive regarding rate hikes.