Bonds are security blanket for investors; Fixed income plays important role in buffering risk in portfolios

March 26, 2014 6:00 am

Bonds are security blanket for investors

By Richard Madigan

Fixed income plays important role in buffering risk in portfolios

Investor patience has been tested this year. While that impatience has translated into higher asset class volatility, it is important to separate the noise coming from event risk, disparate macroeconomic data and fundamentals.

Geopolitical risk remains heightened and the higher risk premiums demanded by investors, because of that rising risk, have supported traditional haven assets including gold, the yen, the US dollar and US Treasury bonds.

While the economic data for Europe continue to signal a gradual move out of recession, Japanese reflation is paused ahead of coming tax hikes and wage increases. Both in Europe and Japan, market expectations are rising for additional policy easing ahead. That should eventually help weaken the euro and yen against the dollar, and broadly support equity markets.

Macroeconomic data in the US has simply been confusing. Markets are going to have to wait for the cold weather to work its way through the dissonant data. Weather has also played a large part in supporting commodity prices this year, in particular for soft commodities and livestock. That dissonance also needs to work its way through extended prices. The commodity cycle continues to reflect a more balanced but slow global recovery. Commodity markets are consolidating, not entering a new bull cycle.

Markets were certain to test the Federal Reserve at its first policy meeting chaired by Janet Yellen, and did. US Treasury yields act as the risk free reference rate for all risk assets. Any moves higher in those rates affect pricing of all risk assets – and interest rates in the US are moving higher.

We believe the Fed will wind down its bond buying this year, that it will not have to raise short-term interest rates until mid-to-late 2015, and that policy rates should remain well below what would be considered a normal level into 2017.

Markets were surprised when US 10-year interest rates quickly came back down at the start of this year. But similar to the overshoot in equity markets at the end of last year, the real surprise was the overshoot in bond yields to 3 per cent in December. With disparate macro data, and a flight to safety because of rising geopolitical concerns, it made sense for interest rates to settle back closer to 2.75 per cent than 3 per cent. However, 10-year US interest rates are likely to move towards 3.5 per cent by year-end.

We said early last year we did not expect a “great rotation” by investors out of bonds and into equity markets – and that instead, the rotation into equities would come from cash. This view was based on the observation that most investors held too much cash and too little equity, and were not about to give up on fixed income. Fixed income is their security blanket.

With the current recovery now in mid-cycle and interest rates moving higher, I have been asked why we own any fixed income. The answer is that bonds continue to play an important role in buffering other investment risk in client portfolios. We are simply playing smart defence until yields get to a point when it makes sense to start buying longer maturity bonds again.

Buyers of longer maturity bonds have returned to markets this year, as private pension funds and insurance companies rebalance gains from equity markets back into core fixed income. They are matching assets to liabilities as underfunded liability positions recover. These institutional investors are providing important support for long-term interest rates as the Fed continues to cut back its monthly bond purchases.

Einstein said: “In the middle of everything lies opportunity.” We are mid-cycle in the global recovery, which may frustrate those late to invest but means there is still investment opportunity. In a more normal investment environment, it is important to be invested. Perhaps counterintuitively, mid-cycle markets offer more balanced investment opportunity.

Richard Madigan is chief investment officer at JPMorgan Private Bank