The bull run is over but it’s not quite a bear market yet says Axa’s Chris Iggo

31st May 2013

Bond market volatility is occurring because markets are expecting yields come back into line with expected nominal GDP in the next few years argues Chris Iggo, CIO fixed income of Axa Investment Management.

In a note issued today discussing interest rate risk, he says: “Over the long term the rate of nominal GDP growth is a fair guide to the level of long-term risk free yields. Unconventional monetary policies have pushed yields below the level of expected nominal GDP growth in a large number of countries. This is good in terms of government debt dynamics as nominal growth in excess of funding costs helps debt stability. However, it is not great for those investors hoping to see their portfolios grow in line with the economy. For the US, the latest OECD forecast for nominal GDP growth in 2014 was 4.8%. For the UK it is 3.3% and for Germany 3.6%. A “normalisation” of yields to these levels implies 10-year yields some 200-300bps higher than current levels. This is ultimately the size of the bond yield adjustment that will come when QE ends and when focus switches to a shift in the global monetary stance.”

Iggo says it may not happen for a couple of years, though markets are of course forward looking.

“Not surprisingly it is the parts of the bond market that have the greatest sensitivity to rising yields that have performed the worst during May. And the most sensitive are the longest duration assets, such as index-linked bonds. Meanwhile, those assets with the greatest credit spread and least sensitivity to rates have tended to hold on reasonably well. Our long held positive view on high yield has been vindicated by the relative resilience of bonds in that sector. The Euro HY index is actually up slightly in May while both the US and Euro HY markets have delivered total returns of 4.5% year to date. The lack of a significant jump in equity volatility is helping high yield markets.”

He says that while life is more difficult and the bond bull market over, ultimately rates will be become more attractive. “As I have argued before, it won’t be a bear market until rates go up. That day gets closer all the time and for investors that need to remain in the fixed income asset class there are two strategic considerations – how to invest through the period of rates going higher, and then how to invest when yields have reached their new levels.”

The note adds that eventually global government bonds will become attractive again.

“After being dismissed in recent years there will come a time when a product like global government bonds will look attractive again, and perhaps spread products will look less so. Yields in the US, UK, core Europe and Japan could all be significantly higher on a one to two year horizon while spreads in investment grade and high yield may still be relatively tight if the economy is strong. At that point the strategy will be to be overweight government bonds and long duration – changed times indeed,” it says.

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