Global Bonds Sentiment

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Desperate search for yield keeps global bond prices high
Neil Behrmann
morganstanlye10113.jpg At the start of 2014, the vast majority of forecasters including BOA Merrill Lynch, Morgan Stanley and BlackRock predicted higher yields and lower bond prices. PHOTO: REUTERS
10 Nov5:50 AM

THE global sovereign-bond bull market has embarrassed numerous market strategists, fund managers and other forecasters who were bearish at the beginning of the year. At the start of 2014, the vast majority of forecasters including BOA Merrill Lynch, Morgan Stanley and BlackRock predicted higher yields and lower bond prices.

Instead, US Treasuries and European and Asian long-term government bonds have generally outperformed equities, gold and junk securities. Since the beginning of 2014, medium-term US Treasury bond exchange-traded funds (ETFs) with redemption periods of seven to 10 years have risen by 7 per cent and 20-year Treasury bond ETFs by 17 per cent.

When bond yields decline, the prices of the securities rise and the longer the duration of a bond, the larger the price gain when the yield falls. When yields rise, the opposite occurs.

In 2013, fears that the US Federal Reserve Board would start "tapering", that is reducing bond purchases, brought in their wake a sharp increase in yields and price declines.

But that was a buying opportunity. Yields have since tumbled from their highs that year and global prices have surged. Thus, as the table shows, 10-year US Treasury bond prices have risen by 7 per cent since 2013, German bunds by 14 per cent, UK 10-year gilts by 8 per cent, French government bonds by 15 per cent, Italian by 21 per cent, Swiss and Japanese by 20 per cent, Australian and Canadian by 10 per cent and Singapore 10-year government bonds by 5 per cent. Including interest, the gains are even better.

Europeans, Japanese, and other Asian and South American investors who purchased US Treasuries would have also made large profits from the appreciation of the US dollar.

Following the price surge and yield drop, bond valuations are now rich. In real, inflation-adjusted returns, Italy's real yield of 2.27 per cent followed by Singapore's (1.72 per cent), Australia's (1.13 per cent) and the UK's (1.01 per cent) offer the best values. Japanese 10-year government bonds are the most overvalued by far, with negative real returns of 2.72 per cent. Bond bears caution that stronger growth and fears of inflation plus upward hikes in Fed and other interest rates in 2015 could surprise the market and cause bond yields to jump and prices to decline.

On the other hand, Lacy Hunt, economist at Hoisington, a US Treasury fund manager, and Gary Shilling, an independent economist, who have had the best track record on US Treasury bonds for more than two decades, continue to be bullish. Mr Hunt believes that high government, corporate and individual indebtedness reduce direct investment and consumer spending.

The velocity of money, that is turnover of transactions, is thus still in a downward trend and counters the impact of central bank monetary ease. Moreover, the appreciation of the dollar is causing oil, other commodities and US import prices to decline and this in turn pulls down the cost of living, opines Mr Hunt. Short and long-term rates, notably bond yields, could thus remain low or fall further as there is disinflation and deflation in several countries.

"We believe that a 'risk on' investment climate still prevails, despite the many warning signs related to economic growth and financial markets here and abroad," wrote Mr Shilling in a recent edition of his Insights newsletter. "So we continue our defensive stance towards equities and suggest Treasuries as a safe haven and beneficiary of possible deflation, especially in the eurozone, as well as the strengthening dollar."

Mr Shilling doesn't think the long-term rally in Treasuries (going back to 1981 when long-term yields reached 15 per cent) is over yet. He maintains that Treasuries "are the safe haven in the world" and, secondly, inflation is low and "there's real risk of deflation, particularly in Europe". Both Treasuries and the US dollar are also a safe haven against the possibility of a stock-market decline.

Regardless of whether the bond bulls or bears are correct, pension funds and other investors are continuing to buy the securities to keep their portfolios balanced.
Bond investors heading for heavy capital losses
Mark Mulligan
913 words
5 Mar 2015
The Australian Financial Review
Copyright 2015. Fairfax Media Management Pty Limited.

Bond investors face heavy capital losses on their holdings once inflation returns, says one of the world's most celebrated fixed-income managers.

Michael Hasenstab, who manages government bond funds worth about $US190 billion for Franklin Templeton Investments, says decade of loose monetary policy have made investors dangerously complacent about long-term interest rates.

In fast-recovering economies such as the United States, where he has cut his funds' long positions, inflation will quickly rebuild once wage and consumer pressures cancel out the impact of lower fuel prices, he says.

Even Europe, where the central bank is just about to launch a government bond-buying - or quantitative easing (QE) - program to help stimulate growth, will see inflation return before too long, he said.

"One of the things we've noticed in the marketplace is that there is no inflation premium on almost any asset," he said.

"That's a concern."

Mr Hasenstab, who studied for his doctorate at the Australian National University in Canberra, says QE has distorted long-range interest-rate expectations, leaving many investors dangerously exposed to a massive bond sell-off.

He says institutional investors such as pension funds, which cover long-term payout liabilities with long-maturity bonds, would be left with heavy book losses once yields climbed and prices slumped.

He expects the US Federal Reserve to begin lifting interest rates soon, and then keep tightening to keep a lid on pent-up inflation.

"At the moment, the oil-price effect is having a significant impact on headline, and even core, inflation figures," he said.

"But that will roll off after a year, unless you believe the oil price is going to go down another 50 per cent.

"Certainly we see the need for rates to normalise higher," he said.

"That's why one of our core trades is short US Treasuries."

Speaking exclusively to Fairfax Media during Franklin Templeton's Asia Pacific investor forum in Sydney, Mr Hasenstab said central banks, including the Reserve Bank of Australia, had mostly exhausted their monetary policy tools in the aftermath of the global financial crisis.

"One of the strengths that Australia has is that the central bank is a very strong institution," he said.

"It's done a good job through a whole range of scenarios - the Asian financial crisis, the global financial crisis - and has stood the test of time pretty well.

"But there's only so much a central bank can do when you're talking about competitiveness; it's really up to policy-makers to have competitive trade policies, have a competitive education system, a competitive tax regime.

"Those are the things you can't ask the central bank to do, and those are probably more important in the long term when it comes to Australia's competitiveness vis a vis its neighbours than whether the Aussie dollar is trading at US80¢ or US70¢," he said.

The star contrarians bets on EU outlier Ireland and emerging markets as diverse as Hungary, Uruguay, Ghana, Sri Lanka, Iraq and Mexico have helped his funds return an average 8 per cent a year during the past decade.

However, a large punt on Ukrainian bonds turned sour last year as the former Soviet Union state descended into Russian-backed civil war.

With the local currency tanking, the country facing financial ruin and the International Monetary Fund poised to step in a second time, current losses on the investment are almost half of a total US$8 billion investment.

Other positioning, however, has proved wildly successful. During the height of the 2011 eurozone debt crisis, Mr Hasenstab picked up about 40 per cent of outstanding Irish sovereign debt, earning himself the moniker of "the man who owns Ireland". His faith in the country's ability to come back from the brink paid handsomely.

Taking massive positions in often distressed emerging market debt requires more than just belief in a country's recuperative will; Mr Hasenstab and his 20-strong research team spend a lot of time looking past backward-looking economic data and conventional forward indicators to longer-term structural and cyclical trends.

"There is a lot of information out there; I think in some cases there is data overload, and you can get lost in the weeds," he says.

"When you go to a country, it becomes usually clear that there's one or two issues that are most relevant.

"I would say consistently one of the conversations we like to have is with academic think tanks, with the people who are looking at some of the longer-term issues that are embedded in the country," he says.

"That type of information is more relevant to our investments."

He cites the case of Indonesia, where during a visit he asked someone about the proliferation of cranes in the capital Jakarta and other cities. Rather than just noting the number, he asked who was financing all the projects.

"It was Indonesians who had left, who had taken their money out of the country to Singapore at the start of the [Asian financial] collapse, who were now returning," he said.

"If people who had left in that period of crisis were willing to come back and invest in real assets, that tells you that there is a sense of stability that is meaningful," he said.

"So it's not only the cranes you look at, but who's funding the cranes."

Fairfax Media Management Pty Limited

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A negative world in bond Wonderland
686 words
28 Feb 2015
The Australian Financial Review
Copyright 2015. Fairfax Media Management Pty Limited.

In the "bizarro" world of government bonds, global bond fund managers are lending money for 10 years to Spain at a rate of 1.28 per cent, to Portugal at 1.87 per cent and to the US at just over 2 per cent.

Is it really safer to lend to the southern countries of Europe than to lend to the world's largest economy? The Italian 10-year bond yield is also at a staggeringly low of 1.34 per cent.

Three years ago the yield on the Portugal 10-year bond was more than 17 per cent, while Italian and Spanish 10-year bonds were north of 7 per cent as investors fretted over the break up of the eurozone.

But not any more, or so it seems.

This week Mario Draghi, president of the European Central Bank, said the future of the eurozone was still at risk. "We have not yet reached the stage of a genuine monetary union," he told the European Parliament in Brussels.

But as the European Central Bank gets ready to embark on its bond buying program next week traders are betting, big time, it's going to work. Let's hope so, but that's some sort of move.

Central banks are hoping that by cutting rates and penalising savers, businesses will start borrowing and consumers will start spending.

By slashing interest rates the same central banks deliberately trash their currency, allowing manufacturers to export at more competitive prices. As each country's currency gets weaker, there is hope of an export boom and that, in turn, drags other global central banks into doing the same.

On Friday, JPMorgan's chief economist Stephen Walters told clients he thinks the Reserve Bank of Australia will now cut rates to a fresh record low of 2 per cent when it meets next Tuesday.

So far, record-low yields haven't done the trick because unemployment rates in Europe, in particular youth unemployment, are still high, and if you're worried about your job you tend to save, not spend.

Still, at least the fund managers buying all these government bonds are getting something for lending the money. When they lend to Germany and Finland they do so knowing they won't get all their money back. Hot on the heels of Finland getting paid for raising money for five years, or at a negative yield as they call it on trading desks, Germany has done the same. Investors paid €100.39 for the bond knowing it was worth €100, which is what they will get back.

Bonds are really just IOUs, so think about who you would give $101 dollars to - and be content to get back $100 in five years' time.

There are now 13 countries with a cash rate below zero, where investors pay for the privilege of having the money on deposit.

When this trend started to emerge in 2014, the negative yields were normally confined to the short end of the bond market. That way you were only missing out for a short time, say six months. But now nine countries have a negative yield for two years, six have a negative yield as far out as five years and 10 have a yield of less than 1 per cent for their 10-year debt.

According to JPMorgan, $US2 trillion ($2.6 trillion) of bonds, more than 25 per cent of the European government bond market, have negative yields, below zero. In Australia, the yield on the five-year inflation-linked bond turned negative but that is probably more of a play on the oil price. The benchmark 10-year bond yield is 2.46 per cent.

For some, lending money to governments knowing you will be short-changed is not that different from the US sub-prime housing market where bond fund managers were, seemingly, happy to lend to people who didn't have a job or couldn't pay back the loans when the interest rate changed.

We all know how that one worked out.

Fairfax Media Management Pty Limited

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Bond-weary investors see the beauty of fine art
843 words
13 Apr 2015
The Australian Financial Review
Copyright 2015. Fairfax Media Management Pty Limited.

It is surely no coincidence that at a time when the international art market is abuzz with the scandal of a near-$US25 million ($32.5 million) profit from the sale of a single Modigliani painting, Switzerland last week became the first country ever to sell 10-year bonds with a negative yield.

The scandal in the art market centres on a Modigliani painting, Nu Couche au Coussin Bleu, which the Swiss art broker Yves Bouvier acquired from US hedge fund owner Steven Cohen for $US93.5 million.

Bouvier then onsold the painting to Dmitry Rybolovlev (a Russian oligarch who made his $US8 billion fortune from potash) for $US118 million, reaping a profit of close to $US25 million.

Two months ago, Bouvier was arrested in Monaco and charged with price fixing and money laundering - charges which he denies - before being released on €10 million ($13.8 million) bail.

But while the case no doubt illustrates the lack of transparency in the international art market - which is now estimated to have an annual turnover of more than €50 billion, up from about €20 billion a decade ago - it also highlights the hefty premium that investors are now prepared to pay for assets that allow them to preserve, and even enhance, their wealth in an era of ultra-low interest rates.

Indeed, works of art are increasingly becoming more like financial assets, with investors using them to diversify their portfolios or pledging them as security for other borrowings. And, like other financial assets, the prices that investors are prepared to pay are pushing ever higher as interest rates head edge inexorably lower.

While Switzerland last Wednesday became the first government in history to sell benchmark 10-year debt at a negative interest rate, other countries are likely to quickly follow suit. Already, Berlin is able to borrow at negative rates for up to seven years, while Paris can borrow at negative rates for up to four years.

This extraordinary slump in European bond yields largely reflects the European Central Bank's massive bond-buying program, known as quantitative easing, or QE. Under this program, the ECB has committed to buying €1.1 trillion worth of bonds issued by eurozone governments, which has the effect of pushing bond prices higher while sending bond yields lower.

No doubt this is great news for eurozone governments, which are now able to borrow at much cheaper interest rates. For instance, Spanish 10-year yields have come down from 4.1 per cent in early 2014 to 1.2 per cent at present, while Portuguese yields have dropped from 5.5 per cent to 1.6 per cent.

Lower yields not only make the debt levels of the peripheral eurozone economies more sustainable, they also reduce the risk of contagion from a possible Greek debt default.

But QE's effects are not confined to the bond markets. The ECB's easy money has also helped to push European sharemarkets sharply higher, with bourses in Germany, France, the Netherlands and Italy all up by more than 20 per cent so far this year.

And as investors respond to low European yields by shifting money to other countries such as the United States, the euro has tumbled, much to the delight of European exporters, who are benefiting as their products become more competitive in global markets.

While most analysts believe that the ECB had no choice but to adopt an easy monetary policy in order to try to revive the moribund eurozone economy, they concede that QE is not without its risks.

Perhaps the biggest short-term threat lies in the fact that the US economy is itself showing signs of weakness. If the US central bank decides that the economy is still far too feeble to begin raising rates, the US dollar could start to forfeit some of its gains against the euro.

This would put the ECB in an extremely difficult position, because one of the key ways that QE works is by pushing the euro lower in the hope that stronger exports will boost economic activity. Were the euro to start rising, the negative effects of QE would become much starker, particularly its role in fuelling bubbles in the prices of financial assets, such as bonds, stock and works of art.

But another major uncertainty is the future direction of the oil price. The steep drop in the oil price over the past year has played a role in boosting European consumer spending.

The risk, however, is that if the oil price rises more than analysts are expecting, inflation in the eurozone would quickly climb towards the ECB's target of close to, but below, 2 per cent.

To honour its mandate, the ECB would be forced to curtail its QE policy, which would immediately cause a rise in eurozone bond yields. And at that point, investors would once again start to question whether the debt burdens of some of the peripheral countries in the region were sustainable.

Fairfax Media Management Pty Limited

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Bond sell-off 'correction' expected to fizzle out
Mark Mulligan
536 words
15 May 2015
The Australian Financial Review
Copyright 2015. Fairfax Media Management Pty Limited.
The recent sell-off in bonds around the world has driven yields to year-to-date highs, prompting calls of a "correction" and "rout" as traders and investors unwind positions built up over more than a year.

However, as dramatic as recent movements have seemed, yields are still low by historical measures, say economists.

They also say any further sustained yield increases would have to reflect real economic fundamentals, such as improving growth or changing inflation expectations in Europe and the US.

With retail data this week confirming the spluttering nature of the US economic recovery, and the European comeback still fragile, implied bond returns will ease back, they say.

"Viewed over short horizons, the surge in yields is dramatic," says Capital Economics' Paul Ashworth. "From trough to peak, 10-year government yields in the US, UK and Germany have risen this year by around 70 basis points.

"Step back a bit, though, and these moves pale into insignificance," he said.

The current 0.72 per cent yield on the benchmark 10-year German Bund, for example, looks tiny beside a five-year high of 3.49 per cent in April 2011.

In any case, the retreat from government bonds was more emphatic during the so-called "taper tantrum" of 2013, when the US Federal Reserve said it would begin scaling back its $US70 billion a month bond-buying, or quantitative easing, program.

"The 2013 surge was much larger and it was ultimately reversed," Mr Ashworth said.

Australia's Clime Asset Management has also urged investors not to overreact to the recent bond market correction by dumping yield stocks in favour of equities that typically do better when economies are growing.

It, too, argues that while the recent bond market sell-off was overdue, it has also been overdone.

"A lot of people - commentators and investment banks - are telling investors to get out of yield stocks and get back into growth," Clime said in a note.

"Their reasoning is that bond yields usually rise following a recession as the market predicts an economic recovery and inflation.

"But we don't think this bond correction is indicative of a surge in inflation around the world, or a growth cycle recovery," it says. "The correction was simply indicative of a mispriced bond market."

This view has become the mantra among an array of fixed-income specialists, many of whom foresaw the current volatility in fixed income and currency markets.

They argue that the correction, partly brought on by short-selling tips from a line-up of bond market luminaries, reflects more the easing of disinflationary pressures around the world than the emergence of inflation.

A sustainable pick-up in growth rates would have to crystallise before bond yields settled into an upward trajectory.

For Australia, the bond sell-off, along with weakness in the US dollar, has created a new headache for Reserve Bank governor Glenn Stevens, who is keen to see a lower domestic currency.

Rather than follow convention and fall, the Aussie has climbed more than 3 per cent since the RBA cut the cash rate, for a second time this year, last Tuesday.

Fairfax Media Management Pty Limited

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Asian government debt dumped in global selling

A sell-off in global bond markets is hitting Asian government debt hard, with prices plunging and yields in some countries jumping to their highest in years.

In Singapore, yields on 10-year bonds hit their highest in almost two years, while yields in Australia are at their highest for the year and in Japan hit their highest since November.

It’s a sharp turnaround for Asian bonds, which have rallied this year as investors flocked to the high-yield market seeking alternatives to the near-zero returns of other global markets.

The selling was kicked off by a sharp move in yields on German bonds, driven by factors including signs of growth in Europe and uncertainty over whether Greece will make its debt payments.

But investors are now struggling to explain the magnitude of the sell-off, citing a liquidity crunch as they struggle to sell their bonds quickly. They say fundamental drivers in Asia are still robust.

“Nothing has actually changed,” said Kenneth Akintewe, a portfolio manager at Aberdeen Asset Management in Singapore, which has $US490 billion under management.

“You have to get on to more spurious things like positioning and sentiment, which are difficult to quantify and view.”

Mr Akintewe isn’t changing his bond positions, but says there are now opportunities in some Asian currencies, which have fallen to weak levels against the US dollar. He has reduced his bets against the Korean won and the Malaysian ringgit.

“The market is venting some steam,” he says, and that could provide some opportunities.

In Asia, yields on government bonds have risen as much as 0.36 percentage points over the past three days, with the losses trickling into Asian currencies.

Pension funds and longer-term money managers have increased their holdings of Asian bonds in recent years, but that has also meant trading in and out of the bonds is increasingly difficult, some investors say.

The Wall Street Journal

May 19, 2015 6:44 pm
The wary retreat of the bond bulls
Martin WolfMartin Wolf

Long fall and recent collapses in nominal and real yields on safe securities should be at an end
James Ferguson illustration©James Ferguson
s the three-and-a-half decade long bull market in the highest-rated government debt over? If so, would that be a good thing or a bad one? The answer to the first question is that it seems quite likely that the yield of 0.08 per cent (8 basis points) recorded on the 10-year Bund in April was a low point. The answer to the second question is that it would be a good thing: it would suggest confidence that the threats of deflation and eurozone disintegration are fading. At the same time, this bounce does not mean that a rapid rise in yields to what used to be normal levels is on the way. We should want to see yields rise, but modestly. This is also what we should expect.
Yields on 10-year bonds have behaved like the grand old Duke of York in the nursery rhyme: they marched right up to the top of the hill and then marched right down again. Yields on government bonds of the big advanced economies peaked in the early 1980s: Japan’s peak was near 10 per cent, Germany’s 11 per cent and those of the US and UK 15 per cent and 16 per cent. Then came a decline. Japan’s rates had fallen below 2 per cent by the late 1990s. Yields in the other three countries were between 3 and 6 per cent before the crisis, only to fall far lower still.
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Death, taxes and compulsory saving
Theory suggests that long-term interest rates should be a weighted average of expected short-term interest rates, plus a “term premium”, as Ben Bernanke, former chairman of the Federal Reserve, argues in a recent blog. The premium should normally be positive, even in the absence of default risk. Longer-term securities are riskier than short-term ones, because their prices are volatile. Expected short-term rates should be determined by expected real interest rates and expected inflation. Again, expected domestic real interest rates should be determined by expected global real interest rates and expected changes in real exchange rates. Expected global real interest rates should, in turn, be determined by the expected balance of saving and investment. Finally, special factors, such as risk-aversion — at the limit, outright panic — and purchases by foreign governments and central banks, will also affect the prices of long-term bonds.
Most of what explains the collapse in bond yields (and so the rise in the prices of such bonds) is reasonably clear. Up to the mid-1990s, the dominant causal factor was the collapse in inflation. In Japan, deflation even became entrenched in the 2000s. From the late-1990s up to the crisis, the main explanation was a decline in long-term real interest rates from a little below 4 per cent to a little above 2 per cent, as shown in yields on the UK’s index-linked gilts.
Since the crisis, the dominant factor has been further marked declines in real interest rates. These are close to zero in the UK and US. In America and Britain people expect prices to keep rising modestly, in line with targets, though not in Japan. The European Central Bank’s recent policy measures are designed to keep inflation expectations up in the eurozone. Meanwhile, the risk premium can only be estimated. Over the long run, it has been volatile. Estimates from the New York Federal Reserve suggest it is now close to zero.
Bond yields chart
Many think purchases by central banks are the dominant cause of low yields. The evidence suggests this is untrue, though it has to be a factor. Far more important is the expectation that short-term rates will stay low.
Today, long-term bond yields in the UK and US are remarkably low, given their economic recoveries. One reason is a spillover from the developments in the eurozone. In recent years, the ECB has been successful in eliminating perceived risks of break-up. Its current programme of asset purchases and other measures have also lowered the general level of eurozone nominal yields. But a powerful safe-haven effect also operates, with shifts into Bunds and also Swiss (and other) bonds. Ten-year yields on Swiss bonds became negative when the currency was allowed to appreciate. Ten-year yields on Bunds effectively fell to near zero. (See chart.)
So what might happen now? The following points must be remembered.
yield decomposition chart
First, nominal and real yields are very low in all the important high-income countries. Thus, they are vastly more likely to rise than fall from recent levels, unless sustained long-term growth and positive inflation are over.
Second, yields are astonishingly low in core European countries. If the ECB succeeds with its endeavours and so the recovery continues to gain pace, then yields should rise a great deal. The same should ultimately be true for Japan.
Third, post-crisis headwinds — among them, high levels of household debt — nevertheless are strong. Also important must be the economic slowdown in China. Thus, the equilibrium global real interest rate is likely to remain low by historical standards for quite a long time.
European yield chart
Fourth, sharp rises in expected short-term interest rates and so in long-term conventional yields are only likely to follow a strong recovery (which would drive up real yields) and so perhaps a strong rise in inflation expectations. This is possible. But it seems unlikely. Whether a big jump in yields would be a good thing depends mostly on whether it is driven by optimism about the real economy or pessimism about inflation.
Finally, falls in nominal and real yields below recent low levels would imply a descent into deflation. Central banks can and will prevent that; never say never, but this looks highly unlikely.

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In short, the long fall and recent collapses in nominal and real yields on safe securities should now be at an end. One must hope so. Further declines would be highly disturbing. At the same time, a swift return towards levels considered normal before the crisis seems unlikely and would certainly create some instability. This might well be a turning point. But, given uncertainties, it would be best if yields turned slowly.
Bond volatility rattles investors

862 words
6 Jun 2015
The Australian Financial Review
Copyright 2015. Fairfax Media Management Pty Limited.

After several weeks of relative calm, global bonds have erupted again, with key US and German bond yields this week hitting fresh peaks for the year as investors worry that strengthening growth could rekindle inflationary pressures.

The sale began in eurozone bond markets, with yields on Spanish and Italian 10-year bonds closing above 2 per cent for the first time in 2015. Meanwhile, 10-year bond yields in the US and Germany this week climbed to their highest level of the year. Bond yields rise as their prices fall.

The latest setback has rattled bond investors, who took a drubbing between late April and mid-May as bond prices tumbled on emerging signs that the global growth and inflation outlook is improving. Bond markets have also become more volatile as investors keep a close watch on the US Federal Reserve's plans to raise short-term interest rates some time this year.

Local bond yields, which are heavily influenced by what happens in European and US markets, have risen in tandem.

BlackRock Australia head of fixed interest Stephen Miller points out that although the Reserve Bank cut interest rates in May, Australian 10-year bond yields climbed - in line with rising bond yields in most other developed countries. Miller argues that a further complication for local investors is the delicate balancing act faced by the Australian Reserve Bank.

"The economy is clearly growing below trend and the exchange rate is overvalued, but there are concerns about overly rapid increases in housing prices in some areas." As a result, "the Reserve Bank is trying to balance monetary policy considerations with an eye on competing interests".

But isn't it anomalous to see bond yields, which usually move at glacial speed, rising or falling by a couple of basis points in a week, climbing so sharply? (In just three trading sessions this week, the US 10-year bond rate rose by 27 basis points, the biggest three-day rise since mid-2013 taper tantrum.)

Shane Oliver, AMP's head of investment strategy, agrees that it is unusual. But he adds: "Sometimes bond markets go to extremes like they did earlier this year on the back of deflation fears. And then you can have an extreme movement (as new information comes along that points in the other direction) and then the market moves back the other way - often sharply."

Perpetual's head of investment strategy, Matt Sherwood, adds that the fall in bond prices was exaggerated because many investors had built up long positions on bonds. As a result, he says, "when you had a spike in yields, a lot of these people wanted to cut their positions, which meant everyone was running for the exit doors at the same time. And the lack of recent market liquidity sparked larger than normal bond market losses."

So should investors be worried about these sharp oscillations in bond yields?

"If the bond market is a bit more volatile, but bond yields move within a relatively small range, it will not be a major problem," Oliver says. "But there may be cause for concern if there is significant volatility and a sharp rise in bond yields, because this will result in capital losses for bond holders."

For instance, he says, if the Australian 10-year bond yield climbed from 2.5 per cent to 3.5 per cent, the value of 10-year bonds would fall by 6 per cent. Even if investors earned an average yield of 3 per cent on the bonds, they would still have a negative total return of 3 per cent.

So what's the best approach for investors to take to avoid such losses?

"I think it's time to think hard about how you go about investing in bonds, and the type of bond portfolio you are looking for," BlackRock's Miller says.

In particular, he says, investors need to be conscious of the duration risk in conventional bond benchmarks - the duration of global benchmarks is six years, while that of the local benchmark is about 4½ years. Miller says this means that these benchmarks "have a lot of interest rate risk".

So how should investors protect themselves against rising interest rates? "We argue that investors have to be smart about how they invest in bonds - that they should be less benchmark-constrained and give fund managers more flexibility to invest in a more diversified geographical and sector spread."

Rising bond yields have major implications for investors in other markets. As Oliver notes, a sharp rise in bond yields will put pressure on equity markets, because bond yields are a key factor when it comes to the valuation of shares. Sherwood agrees. "The bond market is the basis for every asset price in the world including stocks, property, credit and so on and, in a world of extremely low yields, every asset globally is overvalued to some extent."

A rise in bond yields "has flow-on effects across the world, especially for yield-sensitive stocks including banks, telcos, utilities and healthcare, which have become almost bond alternatives during the recent global search for yield".

Fairfax Media Management Pty Limited

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Jun 11 2015 at 8:22 AM Updated Jun 11 2015 at 8:35 AM

Bill Gross asks what happens when central banks end quantitative easing

In Bill Gross's words, bond markets are now responding to "fire" calls from Fed vice chair Stanley Fischer and Mario Draghi. FDC

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by John Kehoe
Bond fund king Bill Gross on Wednesday took to Twitter to ask the defining question on the minds of investors around the world: "What happens when it stops?".

It is the multi-trillion dollar liquidity flood from central banks in the United States, Europe and Japan, combined with a further $US1 trillion in share buybacks from American companies.

Investors will soon to get an early taste of edging away from this unprecedented situation towards something more akin to normality when the US Federal Reserve raises interest rates for the first time in almost a decade. Robust US employment growth, tentative signs wages may be picking up and renewed small business confidence reinforce the view in financial markets that September will be lift off for the Fed.

Bond markets are preparing for higher rates, evidenced by the 10-year US Treasury yield on Wednesday hitting 2.49 per cent, its highest level since October. German bond yields are rebounding quickly from historic lows, contributing to a 10 per cent peak-to-trough correction in Germany's stock market index, the DAX, earlier this week. Money is also drifting out of interest-rate sensitive stock sectors like utilities and real estate investment trusts, which have underperformed the market in recent weeks.

On Wall Street, there is a big debate on whether rising rates and a possible end of the 30-year bull run for bonds will be good or bad for stocks.

In Gross's words, bond markets are now responding to "fire" calls from Fed vice chair Stanley Fischer and Mario Draghi. The Janus Capital investment manager says the Fed and ECB want long-term rates to rise from their historic lows to protect pension funds and insurance companies from unsustainably low returns.

Stock market bulls believe the money flowing out of bonds will jump into stocks.

US shares snapped their four-day losing streak on Wednesday, spurred by reports that beleaguered Greece and its international creditors were moving closer to a debt compromise.

The S&P 500 rose 1.28 per cent to 2,106, the Dow Jones Industrial Average soared 1.33 per cent to 18,000.4 and the Nasdaq Composite Index surged 1.37 per cent to 5082.6. Germany DAX rallied 2.4 per cent.

The more circumspect see no reason why there cannot be a sharp selloff in bonds and stocks in unison.

Deltec International Group chief investment officer Atul Lele said: "The greatest risk to markets is higher interest rates, and contagion of interest rate and FX [foreign exchnage] volatility into other asset classes."

David Kostin, Goldman Sachs' chief US equity strategist, is anticipating a Fed hike in September and expects the US stock market to finish the year around flat from current levels.

Like Gross, he worries about the record US company share buybacks that may be propping up stock prices and wonders if it is the most efficient use of capital.

Low borrowing costs have encouraged boards to buy back their own stocks, as they struggle to generate top line revenue growth.

The main short term focus for investors from here will be any clues from the Fed meeting next week.


J2Z Advisory principal Jay Pelosky says investors are pricing in a Fed rate hike in the northern hemisphere autumn. But the problem for investors is that good economic news from here could be bad news for stocks, "because it increases the risk of a Fed rate hike and investors worry about the economy's ability to handle that," Pelosky says.

For that reason, Pelosky says there is a risk of a policy "mistake" by the Fed. In this scenario where the Fed raises rates too soon, the stock market sells off and the resulting reverse-wealth effect weakens the economy.

"Such a prospect is also bad for stocks and bonds and is beginning to be thought through by smart money investors," Pelosky says.

Gross believes that "central banks don't know their way home". In other words, unwinding the unprecedented central bank stimulus over the coming years will be terribly tricky.

For now, markets are probably thankful that the Fed has passed the baton to the European Central Bank and Bank of Japan. But as Gross asked on CNBC, what happens when that music finally stops?

Bond losses mount in 'year of no return'
Dhara Ranasinghe | @DharaCNBC
26 Mins Ago
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Fixed income markets are nursing their worst losses in years, setting the tone for a poor performance that is expected to continue against a backdrop of a recovering U.S. economy and a pick-up in inflation expectations.

Bank of America Merrill Lynch said this week that its global investment grade fixed income index lost 2.23 percent of its value in the second quarter – the worst quarterly performance since 1997 and potentially also the worst since the U.S. Federal Reserve starting lifting interest rates in the first quarter of 1994.

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And with the Fed tipped to soon deliver its first rate hike in nine years, while inflation expectations in the U.S. and Europe pick up, the tide appears to have turned against bond markets, where yields until recently were on a one-way track lower amid weak growth and easy monetary policy.

"We were always concerned that the coming rate hiking cycle could be as disorderly as 2004 – but never imagined getting this close at such an early point prior to lift-off," analysts at BAML said in a note published on Tuesday, referring to a "year of no return."

Read More Is you bond fund invested in Puerto Rico?

"The big picture in our view remains that the unwind of the global liquidity trade has begun, and that means poor return performance and decompression," they added.

Heading for exit

Data released by BAML last Friday showed investors globally pulled $3.8 billion out of bonds funds in the week ending June 24. Government bond funds, which mostly invest in U.S. Treasurys, saw $1.4 billion of outflows.

The benchmark 10-year Treasury yield was trading around 2.44 percent on Thursday – about 80 points above a low hit earlier this year around 1.64 percent. European bond markets have also seen heavy selling that has only been capped by a crisis in Greece spurring demand for safe-haven debt.

Still, Germany's 10-year Bund yield is trading at about 0.88 percent – more than 80 basis points above a record low of 0.05 percent hit in April.

"We think the U.S. economy is recovering; we think the Fed is going to raise rates and we don't think that's properly priced into markets," Myles Bradshaw, ‎head of global aggregate fixed income at Amundi, told CNBC on Thursday.

"That has implications, particularly for the front end of the U.S. bond market, where we think yields are too low," he added.

The yield on two-year U.S. notes, which is sensitive to interest rate expectations, is trading around 0.70 percent.


Thursday could bring a new test for bond markets with the release of closely-watched official U.S. jobs data. Any signs of strengthening in the labor market could reinforce expectations for a September rate hike, pushing bond yields higher.

Read MoreJune jobs report expected to be strong

Asked about his views on the outlook for bonds, Edmund Shing, a global fund manager at BCS Financial Group, told CNBC it was all about inflation.

"People focus so much on demand and supply, what you actually need to focus on for the long-term in the bond market are inflation fundamentals," he said on Thursday.

"If I'm right and inflation is creeping up in the U.S., then why shouldn't bond yields go up?"

Dhara Ranasinghe
Associate Producer

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