Partner Content: Kerry Duffain from Fidante Partners on the advantages of fixed income relative value strategies at a time of bond market volatility and ever-increasing central bank interest rates.
Government bonds play a critical role in the global financial system and are among the most liquid and deep markets in the world. As an important defensive component of portfolios, government bonds offer a lower-risk source of return with high liquidity. However, after an already tough year for bond markets, things got worse in September.
The scale of market falls and level of volatility is the highest in decades in some asset classes but particularly government bonds. The Bloomberg Global Government Bond Index fell another 5% in September, taking year-to-date declines to 20% as major market yields hit the highest levels in a decade or longer. Global equity markets have experienced a similar-sized correction, after registering 5-10% falls over the month.
The global macro backdrop remains very challenging, as central banks aggressively tighten policy to fight historically high inflation into a slowing global economy. The Federal Reserve, European Central Bank, Bank of England (BoE), Bank of Canada, Royal Bank of Australia and other central banks all delivered outsized rate hikes in September. Meanwhile, the extraordinary strength of the US dollar is causing headaches for other global central banks.
The UK has been a major driver of the September turmoil in global markets. Sterling assets experienced emerging market like volatility in the wake of the UK government’s budget update, which dramatically expanded fiscal policy at a time of high inflation and BoE quantitative tightening. Gilt yields experienced their largest ever daily and weekly increases in 30 years and the pound fell sharply as markets questioned the credibility of the fiscal policy outlook.
Subsequent BoE intervention and government statements aimed at easing market concerns saw only a very small retracement in yields late in the month. However, global stocks and the pound rose this week as markets reacted to the news that Rishi Sunak had emerged as the UK’s new prime minister. European and American equities also climbed despite data showing that Britain and Germany are headed for recession.
Similarly, Wall Street opened the week green, with sentiment boosted by hopes the Fed would soon slow its pace of interest rate hikes. The eurozone was meanwhile looking ahead to today (27 October) when the European Central Bank raised interest rates by 75 basis points with the aim of curbing sky-high prices.
For these [relative value] investment strategies, the current high level of stress in bond pricing relationships represents an attractive opportunity set.
Room151’s Monthly Online Treasury Briefing
October 28 2022
Online
Public sector delegates – register here
Relative value strategies
Fixed income relative value strategies take advantage of pricing distortions in government bonds by implementing long and short positions across different maturity bonds to capture relatively cheap and expensive bonds. For these investment strategies, the current high level of stress in bond pricing relationships represents an attractive opportunity set. The underlying pricing relationships between groups of interest rate securities with similar or the same risk characteristics is unlikely to remain this disconnected indefinitely.
In this sense, highly distorted global interest rates are similar to credit markets overshooting fundamental valuations in extreme periods. Importantly, however, unlike credit- or duration-focused strategies, investors can manage through stressed markets in relative value with lower performance volatility as relative value strategies do not employ a “buy and hold” strategy that requires yields to fall or credit spreads to compress to generate alpha.
Kerry Duffain, Institutional Client Solutions, Fidante Partners.
—————
FREE weekly newsletters
Subscribe to Room151 Newsletters
Room151 LinkedIn Community
Join here
Monthly Online Treasury Briefing
Sign up here with a .gov.uk email address
Room151 Webinars
Visit the Room151 channel
