Like just about every other fixed-income investor these days, PIMCO CEO and co-CIO Mohamed El-Erian is now asking a simple yet huge question: What exactly is going on in the bond market?
Yet unlike many others, El-Erian (left) has come up with some solid observations, answers and investment ideas.
“To say that bonds are under pressure would be an understatement,” El-Erian writes in his September viewpoint, “What’s Happening to Bonds and Why?” “Over the last few months, sentiment about fixed income has flipped dramatically: from a favored investment destination that is deemed to benefit from exceptional support from central banks, to an asset class experiencing large outflows, negative returns and reduced standing as an anchor of a well-diversified asset allocation.”
So what’s the takeaway for investors? After writing a long and reasoned report that explains just what is going on in the bond market, El-Erian ends up agreeing with the conclusions his co-CIO, Bill Gross, offerend in a baseball-metaphor-driven investment outlook published earlier this month.
“Specifically, fixed income investors should respect the technicals for now, emphasize the front end of curves on the basis of the policy pivot (from [quantitative easing] to forward guidance), and consider TIPS as a source of endogenous portfolio hedging,” El-Erian writes. “They should look to exploit large technical dislocations that are anchored by upcoming maturities and other self-liquidating characteristics. And, given that the bad technicals will run their course eventually, they should prepare to take advantage of broader overshoots that provide both attractive valuations and solid carry.”
Before the end of April, when the market started its gut-wrenching descent, “the combination of return generation and risk diversification was part of a broader virtuous circle for fixed income, which also included significant inflows to the asset class and direct support from central banks,” El-Erian writes at the start of his viewpoint, noting that in addition to delivering solid returns with lower volatility relative to stocks, the inclusion of fixed income in diversified asset allocations also helped to reduce overall portfolio risk.
That virtuous circle clearly was reflected in positive investment returns. Over the last 20 years, a diversified portfolio of high-quality bonds, as defined by the widely followed Barclays U.S. Aggregate benchmark, delivered strong returns, El-Erian notes. The benchmark’s annualized 20-year return delivered 6% while the 1-, 3-, 5- and 10-year returns stood at 3.6%, 5.4%, 5.6% and 5.0%, respectively.
But that was then.
“All of this changed markedly starting in April 2013,” says El-Erian. “Since then, the Barclays U.S. Aggregate has delivered a negative return of 4.5% (May through 6 September 2013) and bond funds have experienced sharp outflows.”
PIMCO’s CEO then reviews what he describes as the Federal Reserve’s “highly unconventional and experimental set of policy tools” used to repress interest rates.
“Specifically, in an attempt to use the portfolio channel to trigger a beneficial combination of the wealth effect and animal spirits, central bankers supplemented their traditional policy lever (namely, a federal funds rate floored near zero) with two more unconventional policy tools: aggressive policy statements (or 'forward guidance') and large-scale market purchases of U.S Treasuries and mortgage-backed securities ('quantitative easing' or QE),” El-Erian writes.
This year, with the Fed’s tightened rates, the U.S. economy was showing definite signs of improvement. But the markets were spooked nonetheless on May 22, when Fed officials began sending signals of their intention to taper their experimental support for markets and the economy.
And that, in a nutshell, sums up the problem, according to El-Erian.
“The ensuing reaction of markets has been quite extreme,” he writes. “The sharp move in interest rates has been accompanied by an increase in volatility, pockets of liquidity dislocations, and unstable and changing correlations.”
In addition to market perceptions of an improving economy and a policy change, these market movements have also been driven by notable shifts in financial asset preferences and related flows, along with some rather nasty market technical, El-Erian says.
Here are just a few of the “nasty” flows and factors that El-Erian mentions:
- After a first quarter of record inflows, approximately $106 billion has exited global fixed income mutual funds in 2013, with U.S. retail funds particularly hard hit.
- Risk parity investors have delevered quite forcefully due to an increase in rates and volatility, spiking correlations and aggressive drawdown control rules.
- Hedge funds have cut back on carry trades, particularly front-end exposures, despite the Fed’s guidance that it will maintain near-zero interest rates for an extended period of time.
- Broker-dealers have little appetite for inventory, thereby reducing the ability of markets to facilitate normal risk transfer.
“Add to all this the selling by central banks (reserve managers) in emerging economies and a slow shift to lower duration benchmarks, and the result resembles for now a ‘technically damaged,’ asset class,” El-Erian writes. “In addition, with the recent decline in investor concerns about Syria, Europe and China, the attraction of Treasuries as a flight to quality has receded in the most recent weeks.”
To conclude his gloomy outlook, El-Erian attempts a bit of positive thinking: “History is unlikely to record a change in the important role that fixed income plays over time in prudent asset allocations and diversified investment portfolios — in generating returns, reducing volatility and lowering the risk of severe capital loss,” he writes.
Prudence and diversification are excellent and true investment themes for investors who are willing to wait — but that sort of investor seems to be in increasingly short supply during this turbulent time.
Read PIMCO’s Gross Dodges Total Return’s Strikeout With Baseball Metaphors at ThinkAdvisor.