Inflation, bonds and Donald Trump

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In the run up to the US election last month, there were many predictions published as to how markets would respond. The fact that Dow Futures were down over 600 points on the evening of 8 November 2016 pointed to an equity market meltdown.

In fact, the equity market rallied…however, that was the beginning of the largest rout in US bonds in 30 years. In this article Grant Samuel Funds Management explores the impact that interest rates, inflation and the Trump factor may have on global bond markets.

A fixed income 101 recap

Bonds are often used in a portfolio as a defensive position that is generally uncorrelated to equities. To understand how the current environment is impacting fixed income investments, it is worth revising three key features of this asset class:

1. Bond returns are comprised of two components – repayment of capital, and interest (or coupon) payments. For example, if an investor was to buy a 10 year fixed income security at issue for $100, receive an interest rate (or coupon) of 5%, and hold it to maturity, it would look like this:

 

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2. There is an inverse relationship between the price of a bond and its yield. As interest rates fall, bond prices increase. Conversely, a rise in interest rates will result in the decline in the capital value of a bond.

 

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3. The structure of bond cash flows has an embedded absolute return. All other asset classes require a buyer to determine value (and for price discovery as well) … except bonds!

Bonds have a natural buyer in the issuer, whether a company, a government or other party. The issuer is required to pay back the loan (bond) at full value when it reaches its stated maturity date. This gives bonds a greater predictability of returns and a natural “curing” mechanism during periods of volatility.

A powerful consequence of this natural buyer is that bonds that have sold off in the marketplace due to technical reasons (such as reacting to movements in interest rates, the stock market or credit spreads) will naturally pull back to their maturity price over time; i.e. the pull to par effect.

The current fixed income environment

When Donald Trump became president-elect on 8 November 2016, a huge drop in Dow futures suggested a bloodbath on US equity markets the following day. To the surprise of many, the Dow rallied and led global equity markets higher. On the other hand, bond markets fell, leading a number of commentators to suggest that the 30-year bull market in US bonds was over. As illustrated by the following chart, 10-year government bond yields in a number of developed markets rallied, leading to a decline in bond prices.

 

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Bond yields are generally a function of interest rates, expected inflation, and credit risk. In the case of the US, there is little credit risk in the government bond market; as a result, bond yields are generally driven by inflation expectations.

The following chart, created by fixed income specialists Payden & Rygel (Payden), looks at what Payden dubbed ‘Trump-flation’, the impact that the election had on the long term US inflation outlook. According to Payden, since Donald Trump became the president-elect of the US, inflation expectations have soared.

 

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As a proxy for long-term inflation expectations, Payden plotted 5-year, 5-year inflation swaps denominated in USD. A 5-year, 5-year inflation swap is a derivative trade where one party agrees to pay a fixed rate, receiving the floating future inflation rate for five years, starting five years in the future. On this measure, inflation expectations hit their highest levels in the past two years in the first week of November, with the market now expecting inflation to average ~2.5% annually five to ten years in the future. Central bankers should take note—Trump’s election moved inflation expectations more effectively than large doses of quantitative easing (QE).

Inflation expectations in the US jumped on the election of Trump; during his campaign he promised fiscal stimulus via tax cuts and infrastructure spending.

Inflation is considered a negative for bonds because it erodes the purchasing power of a bond’s future cash flows. For example, if a 10 year bond pays a coupon of $500 every six months, rising inflation means that $500 will buy less 10 years from now; or in other words, investors’ money will be worth less in the future. With higher expected inflation, investors will demand higher yields to compensate for inflation risk; and when investors worry that a bond yield won’t keep up with the rising cost of living, the price of the bond drops because there is less demand for it.

According to Payden, that although the media was quick to tout the bond rout, not all bonds followed the full extent of the US Treasury market’s lead. For example, as illustrated in the following chart, 10-year German bund yields remain low. Payden suggests this may be due to the scarcity of high-quality government bonds in circulation in the euro area. The spread – or difference – between US and German government bonds hasn’t been so wide since 1989.

 

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Merkel and the Bundesbank are fiscally conservative, and a significant amount of austerity will remain throughout much of Europe. Such austerity, along with the looming problems of Brexit and of what may well happen in forthcoming Italian and French elections, may depress growth in Europe, whereas growth may accelerate in the US.

Unconstrained versus traditional bond funds

An unconstrained investment strategy is one that is not beholden to a benchmark; rather it is designed to be better able to navigate the complexities of the evolving fixed income landscape than traditional benchmark aware bond funds.

This is particularly important in the current economic climate with a wide disparity in yields; low to negative in countries such as Japan and Switzerland, while on the rise in the US. In an environment with divergent yields, high volatility and a lot of uncertainty, traditional benchmark-based approaches to fixed income investment can be less effective.

Traditional bond funds are managed against an applicable bond index, which are generally most heavily weighted to the biggest debtors. Global fixed income indices measure two exposures: country exposure, generally weighted towards those countries that have issued the most debt, and security exposure, also weighted toward those that have issued the most debt. If the index has a longer duration profile, the fund generally reflects that duration too.

Unconstrained strategies are typically managed to beat a cash or equivalent benchmark, rather than a bond index; this removes constraints around duration and sector positioning. This can result in a fund that has the flexibility to dynamically alter its investment mix to find the best opportunities across securities, duration and geography.

Despite the uncertainty in the bond market globally, an allocation to fixed income securities remains an integral part of a diversified portfolio. The most important consideration becomes the selection of an appropriate investment for the market conditions. Any framework that targets a positive return from fixed income will focus on the front end of the yield curve, five years and in. As long as the entity that has issued the bond is solvent, other issues, such as interest rate moves, geography or sector allocation become less important.

According to Payden, an unconstrained strategy is best placed to prosper in an environment where rates are moving sideways or rising; in a falling rate environment, traditional benchmark aware funds tend to outperform. However, given how low rates are in most markets, this is the least likely scenario for many years.

Taking an unconstrained approach – thinking about generating positive returns rather than relative returns to a benchmark – is more likely to win over the coming years, while portfolios anchored to a benchmark are likely to remain challenged in this environment.

 

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This article provides general information only and has been prepared without taking account the objectives, financial situation or needs of individuals. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management ABN 14 125 715 004 AFSL 317587 (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2016 Grant Samuel Fund Services Limited.

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