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Bond market: Investment opportunities on yield curves

Anticipations on future monetary policy and risk aversion linked to systemic threats create investment opportunities on the yield curves of US and Euro bonds. However, those opportunities cannot be seized before two fundamental questions have been answered

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I have recently developed some perspectives on the future evolution of the CAC 40. The same analysis can be carried on bond markets and we can subsequently think about the strategies that can be applied on the yield curve for US and Euro bonds.

Two major elements must be taken into consideration the first one being anticipations on future monetary policy. The second one deals with systemic risk arising from bank risk which still prevails despite pledges for bailout plans and recapitalization. Bank default risks remain unquestionably present. Systemic risk can also derive from the default of a “large” sovereign state such as Spain and Italy in spite of reform expectations on the European Stability Fund which has been given the role of a bank or insurer. (I’m preparing an article on the subject).

Anticipations of low interest rates in the US that will last until 2013 and the probable decrease of the BCE Repo rate should allow the 2 year maturity on the forward curve to continue outperforming the 10 year maturity both in Europe and the US. It is expected that a greater focus on the 2 year maturity would enable a better performance to be achieved out of the European bands since the any further drop in US is very limited. What is “certain” is that considering the absence of any potential interest hike in the US and Europe, any risk of loss on this part of the forward curve is almost non existent.

The 10 year maturity will remain driven by risk aversion and flight to quality. This explains why there has not been any major trend on the 2-10 year maturities in the US or Europe during the past weeks. There has neither been a flattening nor a steepening of the curve. This is due to the fact that 2 year rates have dropped following anticipations of a prolonged accommodative monetary policy and 10 year rates dropping under the weight of safe haven buying on US treasuries (despite the US downgrade by S&P) and on the German bund (favoured against the Spanish Bono, Italian BTP and to a lesser extent the French OAT).

Beware of long term rates of these area considered as safe havens over the coming months. The idea goes as follows: Why are the long term rates on government (Zones considered as safe havens) bonds so low ? Secondly: why they rise violently?
Mory Doré

These two questions can be answered simultaneously by take four elements into account.

- 1/ Western public deficits (the US in particular) continue to be financed (monetized) by direct or indirect quantitative easing (The Bank of England has recently announced a new 75 billion pound QE programme; the FED is setting up its Twist operation aiming to flatten the forward curve by favouring the purchase of long term government bonds against short dated ones. Western public deficits are also monetized with security purchases from Asian central banks which still have excess reserves to invest. Since they have to remain competitive, they resort to buying dollars and euros against their own currencies.

Financial markets: hedging against new structural risks and stagflation

There are at least four new structural risks to consider: regulation, Middle East, euro zone’s crisis, and again the idea of a change in growth model of emerging countries.

We should be careful about the upcoming change in the model of emerging economies (this is being a more frequently discussed issue). It should however that no drastic change is expected anytime soon such as a profound change in the Chinese currency regime for example. The current situation consisting of accumulating currency reserves from money printing in order to sell them against the USD and to a lesser extent the EUR through government bond purchases denominated in the latter currencies could continue for a while. We should nonetheless start seriously considering an upcoming change in the Chinese economic growth model which is currently based on exports and consequently on foreign exchange accumulation. The model that would prevail instead would be one based on domestic growth. When these days will come, capital repatriation from China and emerging Asia will cause an increase in long term rates on government bonds on both sides of the Atlantic.

Besides, we are seeing foretelling signs of this change. For example, China no longer prevents its currency from appreciating like it did previously and has recently reduced currency accumulation in order to allow for a sharper appreciation of the RMB. In addition, the Chinese authorities are starting to apply a policy designed to support domestic demand which will lead to a reduction in trade balance excess and consequently develop the need to accumulate more foreign exchange reserves invested in Western government bonds.

- 2/ The monetary policies of the major central banks remain highly accommodative and keep expanding but the banks cannot indefinitely accumulate “transforming positions” (10 year government bond purchases refinanced by short term interest rates) or they will put their balance sheets at risk. Besides, the setting up (even if it is not being considered on the short term) of the NFSR (Net Stable Funding Ratio) will end this logic of transformation.

The NFSR is the ratio between the amount of financing considered as stable and available (capital and resources with a maturity exceeding one year) and the estimated amount on financing requirements on maturities exceeding one year.

Reconciling bank processing and prudential regulation

The introduction of new liquidity ratios could undermine banking core business

The need to maintain a utilization / resource ratio which is higher than 100% on maturities exceeding one year will considerably reduce the transforming capacity of banks. It will put back into question the most basic function of the bank which consists in transforming maturities and long term utilization of resources borrowed on the short term. Therefore among other things, this would force a reassessment of the reemployment of quasi free liquidity in long term government bonds during periods when the forward curve has a steep structure. This is reinforced by the fact that these bonds are put in the central bank in order to benefit once again form central bank liquidity…it has been a never ending story until now except it will no longer be possible to carry out such activities with the new constraints.

- 3/ Risk aversion maintains a structural situation of safe haven seeking towards assets judged as non risky :These would include government bonds from the US, the UK and the core Eurozone. But how can we be sure that sovereign bonds judged as safe will continue to benefit from flight to quality? Other assets considered as safe havens and which are not overpriced could take over. Among those would figure gold despite its trend. Besides, its quality as a real asset shelters it from a price bubble. Also included are corporate securities with strong fundamentals, indexed linked securities and securitized cash securities backed by tangible discounted assets benefitting from renewed interest. Emerging assets (sovereign, corporate and equity) would also be part of the assets involved.

I personally invest very serenely within a long term strategy plan on some real estate securitizations, on SCPIs (French investment vehicle enabling real estate investment), on gold, on some corporate and emerging sovereign bonds and on some OECD corporate bonds in defensive sectors such as utilities. I am however not ready to take on massive exposure on long term bonds (beyond 7 – 10 year maturities) on some OECD countries which are still considered as being safe (US, UK, France…)

- 4/ Evolutions tied to prudential regulation (namely Basel 3) encourage the accumulation of government securities. But then again, who can guarantee us that investors will accept to purchase government securities with a return of 2% (or less) based solely of regulatory reasons? Will we see investors continuing to run towards 2% government bonds or even below that level if flight to quality continues in order to build a liquidity reserve which is eligible to the LCR (Liquidity coverage ratio which would normally be applied to the European banks as from 2015 but which needs to be followed as from now). Or will they, which I believe, impose a risk premium…It is indeed probable that faced with the non sustainability of their public debts during a period of low economic growth, the default risk of some Eurozone states will rise (we are not talking about Greece which is already officially in default despite all the noise going on around it. The countries concerned are rather Portugal, Italy, Spain and even Belgium). In these conditions, we cannot imagine the banks continuing to invest with their “eyes closed” on these government securities considering the expected haircuts resulting from restructurings and therefore capital destruction.

We shall remind that the LCR is a short term ratio which requires the banks to hold a stock of risk free assets which are easily negotiable when compared to net stressed outflows over a period of 1 month. This ratio is more restrictive in terms of liquidity constraint on a 30 day horizon than the current 1 month liquidity coefficient.

In short, the 4 major reasons which explain the exceptionally low level of long term interest rates could quickly turn into negative factors and sow the seeds of a future bond krach in the US, the UK, France and Germany. However, this is more likely to take place during the second half of 2012 and we should get ready for this as soon as the spring of 2012.

For the time being, in terms of bond and arbitrage strategies, I would significantly underweigh the 10 year maturity in favour of the 2 year.

As far as the 2 year term is concerned, I would favour the Eurozone compared to the US zone (Higher potential of a drop in interest rates by the ECB which is non existent as far as the FED is concerned). On the 10 year maturity, I would however favour the US instead of the Eurozone (Anticipation of mutualisation of sovereign risk in the Eurozone through the creation of Eurobonds even if this is a distant prospect. This would weigh on the 10 year bonds of the core Eurozone countries. At the same time, it is expected that Asian central banks will maintain their treasury purchases).

Finally, the descending order of my government bond investment would be as follows: 2 year Euro, 2 year US, 10 year US and 10 year Euro.

Mory Doré October 2011

Article also available in : English EN | français FR



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