Welcome return of bond volatility

June 7, 2013 5:24 pm

Welcome return of bond volatility

By Michael Mackenzie in New York

Long a benign indicator, the temperature gauge of the US bond market is flashing on the dashboards of investors; volatility is back and it should be welcomed not feared. Thanks to the Federal Reserve staking out a flexible approach to scaling back its $85bn a month bond-buying programme, bond prices have been fluctuating to a degree not seen since the US debt ceiling fracas during the summer of 2011. Trading in currencies, equities and emerging markets has also felt the lash from bigger swings this week, leading up to the release of employment data on Friday. The creation of 175,000 new jobs last month only fans uncertainty as to when the Fed may look to reduce its hefty bond buying later in the year. It means the turmoil we have seen across markets is not going to fade any time soon as investors take a hard look at their bond portfolios. This is particularly so as their benchmark, the Barclays US Aggregate Index, has registered a slide of around 1 per cent, its worst performance at this stage of the year since the savage bear market of 1994.Not surprisingly, money is being pulled from bond funds, which have enjoyed massive inflows in recent years. This past week saw a record outflow from US junk bond funds, accompanied by hefty withdrawals from other areas of fixed income.

The danger is that, as fund outflows accelerate, forcing bond managers to sell more of their holdings, the bond market could enter a nasty period where volatility feeds on itself and fuels a major meltdown.

This scenario is the big risk for US policy makers seeking to map out their exit strategy after years of aggressive monetary policy.

For now the return of bigger price swings in bonds amounts to a welcome restoration of market discipline.

Volatility matters greatly to investors, who quickly retreat to the sidelines when prices of bonds and equities are swinging wildly. Taming the volatility rollercoaster explains why the Fed’s suppression of interest rates via quantitative easing worked so well until the start of May.

Perhaps too well, for without question the lack of volatility encouraged plenty of excessive risk taking by investors, a fact that has not been missed by policy makers.

Last month Ben Bernanke, Fed chairman, told a Congressional committee, “investors or portfolio managers dissatisfied with low returns may “reach for yield” by taking on more credit risk, duration risk, or leverage”.

Such complacency among investors has certainly been challenged. Looking at the sharp jump in Treasury yields to 2.20 per cent from 1.60 per cent since the start of May, it is easy to conclude that is where most investors have been hurt. Except many fund managers shunned government bonds and placed their money in higher yielding mortgage securities, corporate bonds and emerging markets.

A lot of positioning has been levered, particularly in the case of mortgage real estate investment trusts, leaving them vulnerable to a sudden and unexpected shift in prices. Driving Treasury yields higher in recent weeks has been the need among investors to hedge the underperformance of mortgages and the sharp rise in volatility by selling government bonds.

Then there have been other so-called yield enhancement strategies, such as selling option premiums on interest rates that garner an upfront payment like insurance underwriting. So long as rates remain stable, the writer of options keeps the premium and it boosts their bottom line.

The common thread here is these strategies all work well when markets are predictable, which is no longer the case.

“The first instinct for leveraged participants is to unwind those strategies that worked well in a low and falling interest rate environment,” says Marc Chandler at Brown Brothers & Harriman.

In this respect, it amounts to some air escaping from asset markets that to many observers were looking like investment bubbles thanks to open ended QE.

Bond investors are not happy at the moment, and some have been hit hard by the recent back up in yields. The return of volatility well before the Fed starts paring monetary stimulus is a welcome rap across the knuckles of people who have bet big on a friendly central bank.