Bonds: the calm before the (bullish) storm?


Fund Commentary
21 Apr 2017


In March, US economic indicators were led by strong housing and unemployment figures and consumer confidence data at a 16-year record high. The Fed raised its key rate to 0.75%-1% and still expects two more rate hikes this year, despite Ms Yellen confirming that the FOMC will adopt a cautious approach to further rate increases.

In Europe, another strong set of data showed evidence of accelerating growth. For the first time since 2012, German inflation was above the ECB’s target (2.2%). This unexpected data led to speculation about a change in the behaviour of the ECB. Markets started to consider that a rate hike before the end of the QE program could be possible as the deposit rate could be raised from its current deeply negative level (-0.4%). In the meantime, the last round of TLTRO was allocated this month.

In Emerging Markets, the PBoC (Chinese Central Bank) raised its short term interest rates for the second time this year in order to halt the outflow of money sent abroad by the Chinese. In South Africa, President Zuma finally decided to fire his finance Minister, Mr. Gordhan. This could lead to a drop in confidence in the country and possible rating downgrades from Investment Grade to Junk.

In this context, the 2y US Treasury yield barely moved from 1.26% to 1.25% (-1bp), the 5y from 1.93% to 1.92% (-1bp), and the 10y & 30y were unchanged at 2.39% and 3.00% respectively. At the same time, the 30y inflation-linked Treasury yield remained at 0.91%, leading to a stabilization of the inflation breakeven at 2.09%. In addition, the 3 Month USD LIBOR increased from 1.06% to 1.15%. In Europe, the 2y German yield increased from -0.90% to -0.74% (+16bps), the 5y yield from -0.57% to -0.38% (+19bps) and the 10y Bund from 0.21% to 0.33% (+12bps). At the same time, the French 10y OAT yield “only” increased from 0.89% to 0.97% (+8bps), the Italian BTP 10y yield increased from 2.08% to 2.31% (+23bps) while the Spanish 10y bond yield hardly moved from 1.64% to 1.65% (+1bp). On the credit side, the European iTraxx Main stayed around 73- 74bp while the US corporate CDX index slightly increased from 62 to 66bps (+4bps). In Emerging Markets, the CDX 10y EM index slightly decreased from 274 to 271bps (-3bps).


During the month, the Investment Adviser decreased the short Bund position built in February. At month end, the Fund was short 30 Bund contracts instead of 60. He built a new position, Vodafone 2022 bought at ASW+33 switched against the sale of the remaining stake in Nederlandse Gasunie 2022 (sold at ASW+5). He also slightly decreased the weight of BMW, TenneT, Enexis and Würth. As a result, the Modified Duration which decreased sharply from 2.3 to around 0.8 in February, increased to 1.4. In terms of portfolio diversification, the Fund held 36 issues from 35 different issuers.


During the month, the Investment Adviser took the decision to buy back the short position in the 10Y Note Future market built in February. He also switched two thirds of the position in 30y TIPS (inflation-linked Treasuries) into nominal US Treasuries maturing in 2047 (purchased at 3.02%). He also decreased the weight of Microsoft 2018, which was yielding just 15 bps above Treasuries. As a result, the modified duration, which decreased from 3.5 to 2.9 in February, climbed to 3.7 at Month end. In terms of portfolio diversification, the Fund held 40 issues from 37 different issuers.


In March, the Investment Adviser lowered the weight of low beta countries and issuers such as Romania, Slovakia, Poland, Lithuania, Latvia, Codelco (Chile) and Cofide (Peru). He also sold the remaining stakes in two bonds with a 30y maturity, Indonesia 2046 and Pemex 2044. From the very beginning of the “carne fraca” scandal in Brazil, he sold the remaining stake in BRF 2024 (sold $1 million at ASW+317). At the same time, he built a new high beta position in Mexico 2027 (bought at 3.89%, Treasury+148) and he switched Sberbank 2019 (2.76%, Treasury+142) into Sberbank 2022 (3.92%, Treasury+199). In addition, in line with the strategy implemented in the Strategy Global Bond Fund, he bought back the short position in 10y Note futures built in February. In terms of geographical breakdown, the top 3 countries were Russia (13.6%), India (11.8%) and China (11.2%). The rating allocation was 61.8% Investment Grade and 36.1% BB+ and BB. The breakdown of the portfolio in terms of market allocation was 96.6% Emerging Markets, 1.3% Developed Markets (i.e. Luxembourg/ArcelorMittal) and 2.1% cash. In terms of sector allocation, the Investment Adviser favoured Governments (42.5%) followed by Materials (18.0%) and Energy (14.7%). The modified duration, which decreased significantly from 5.8 to 4.6 in February, increased to reach 5.3 at month end. In terms of portfolio diversification, the Fund held 32 issues from 32 different issuers.


The Investment Adviser’s medium-to-long term global outlook is still very cautious but in the short term, he believes that a bond rally is likely in April-May. This is the reason why he decreased the short Bund position and removed entirely the short 10y treasury position. In addition, he is convinced that inflation fears will decrease substantially in the US and that it is time to take profit on inflation-linked Treasuries (TIPS) and re-invest in traditional nominal T-bonds. Markets will remain very volatile in April-May, due to the uncertain outcome of the Presidential election in France. In addition, the Investment Adviser will monitor closely the evolution of high beta Emerging markets in order to seize any opportunity to reinvest in these regions which, probably, offer the best risk-reward profile in the bond market.


The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 18/04/17 and are based on internal research and modelling.