Could 2016 Be Another Bond Bull Market?

When the Federal Reserve raised interest rates in December forecasts confidently predicted four more rate rises in 2016 - but market volatility year to date has forced a backtrack

Emma Wall 19 January, 2016 | 12:43AM
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Emma Wall: Hello, and welcome to the Morningstar Series "Why Should I Invest with You?" I'm Emma Wall and I am joined today by Jim Leaviss, Head of Retail Fixed Income for M&G.

Hi, Jim.

Jim Leaviss: Hello.

Wall: So, I thought we'd start with the Fed raising rates last month. Of course, it's not a new subject, but the way the markets have taken it, means that it constantly renews itself. And so far as when they raised rates last month, the consensus view was that there's going to be another four to six rate rises throughout 2016 and already there has been a lot of backpedaling on that and people are saying; one, two, maybe even a cut. Where do you sit on that?

Leaviss: It's quite interesting that immediately after the Fed hiked rates, markets were really well behaved. Somebody even produced T-shirts said I survived the Fed rate hike of 2015. I think they sold a lot of those and people want their money back by now, as we come into January in the equity markets, in bear markets, and rather than four rate hikes priced in for 2016, the markets rolled that back really aggressively. So, perhaps one from the Fed, nothing from the Bank of England all year and we're in a kind of depressed mood where we think that the world is going to fall off the cliff economically again.

I think there are lots of reason to be cheerful and to say it is right that the markets have taken away some of the Fed tightening they had in. But at the end of the day, the oil price is halved for almost two years in a row now and that will have a massively stimulatory effect on the global economy. So the U.S. jobs markets still very strong, cheap energy those are the good news stories that mean eventually the Fed will be able to raise rates again, but it won't be as quickly as the market had thought it was going to be back in December and earlier.

Wall: I suppose what that means is bad news for savers, those individuals who really hope they're going to get a bit more for cash, but actually good news for bondholders who have had a pretty good run of it and that may continue for another year?

Leaviss: Yeah, I mean, it could well do. You've seen government bond yield to be really quite stable despite the rise in expected interest rates around the world. You still only get 2% for investing in the 10-year U.S. Treasury bond and it's quite difficult to see why that would go up to 2.5%, 3%. The rates of Fed hikes, even though we are going to get hikes, the terminal rate where the Fed ends up, where the Bank of England ends up is going to be much lower than it ever was historically and that means the downside for fixed income is perhaps not as aggressive as the market may have once thought.

The one fly in the ointment might be that one of the biggest holders of U.S. Treasury bonds, of GILTs and BUNDs is the Chinese government effectively they've built up trillions of dollars' worth of reserves in U.S. Treasury bonds. And as the Chinese economy goes into reverse, while the numbers out today, say, if you call 7% growth, if you believe that reverse that's a nice place to be. But nevertheless, they are selling down billions and billions of government bonds and that might be a thing that enables yields to drift slightly higher.

So, in my fund, the Global Macro Bond Fund, I still want to be underweight government bonds at this point, not just because rates are going up but also you have this big persistence seller of government bonds going forward.

Wall: I suppose then the flip of that is where do you want to be? If you don't want to be in U.S. Treasury bonds, where are the opportunities?

Leaviss: Well, if you look at what's been the worst performing asset classes in fixed income world, it's been in U.S. high-yield bonds and it's been in emerging market bonds. We've been heavily underweight in those two areas for a very long time, and because in emerging markets we've been waiting for the Chinese slowdown to come, haven't owned them. But when you see the Brazilian real is depreciated by 30%, 40%, the bonds are yielding 15%, 16%, 17%, and that's true across all of the emerging markets. I think that 2016 there will come a turning point when you say, actually the oil price was half from 100 to 50 to high 20s, is it going to go down to 12? It might well do, but nevertheless, there will be an opportunity in commodity bonds, in energy bonds and even emerging markets bonds.

We have Claudia Calich, who I know has been on here before talking about emerging markets. She works in my team and there will come a time, she reckons with two-thirds of the way through the sell-off in emerging markets, but hopefully there will come a time in 2016 where you want to pull the trigger and say, well, I'm not going to get double digit yields in any other bond asset class and this is the time to invest there.

Wall: Jim, thank you very much.

Leaviss: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

Emma Wall: Hello, and welcome to the Morningstar Series "Why Should I Invest with You?" I'm Emma Wall and I am joined today by Jim Leaviss, Head of Retail Fixed Income for M&G.

Hi, Jim.

Jim Leaviss: Hello.

Wall: So, I thought we'd start with the Fed raising rates last month. Of course, it's not a new subject, but the way the markets have taken it, means that it constantly renews itself. And so far as when they raised rates last month, the consensus view was that there's going to be another four to six rate rises throughout 2016 and already there has been a lot of backpedaling on that and people are saying; one, two, maybe even a cut. Where do you sit on that?

Leaviss: It's quite interesting that immediately after the Fed hiked rates, markets were really well behaved. Somebody even produced T-shirts said I survived the Fed rate hike of 2015. I think they sold a lot of those and people want their money back by now, as we come into January in the equity markets, in bear markets, and rather than four rate hikes priced in for 2016, the markets rolled that back really aggressively. So, perhaps one from the Fed, nothing from the Bank of England all year and we're in a kind of depressed mood where we think that the world is going to fall off the cliff economically again.

I think there are lots of reason to be cheerful and to say it is right that the markets have taken away some of the Fed tightening they had in. But at the end of the day, the oil price is halved for almost two years in a row now and that will have a massively stimulatory effect on the global economy. So the U.S. jobs markets still very strong, cheap energy those are the good news stories that mean eventually the Fed will be able to raise rates again, but it won't be as quickly as the market had thought it was going to be back in December and earlier.

Wall: I suppose what that means is bad news for savers, those individuals who really hope they're going to get a bit more for cash, but actually good news for bondholders who have had a pretty good run of it and that may continue for another year?

Leaviss: Yeah, I mean, it could well do. You've seen government bond yield to be really quite stable despite the rise in expected interest rates around the world. You still only get 2% for investing in the 10-year U.S. Treasury bond and it's quite difficult to see why that would go up to 2.5%, 3%. The rates of Fed hikes, even though we are going to get hikes, the terminal rate where the Fed ends up, where the Bank of England ends up is going to be much lower than it ever was historically and that means the downside for fixed income is perhaps not as aggressive as the market may have once thought.

The one fly in the ointment might be that one of the biggest holders of U.S. Treasury bonds, of GILTs and BUNDs is the Chinese government effectively they've built up trillions of dollars' worth of reserves in U.S. Treasury bonds. And as the Chinese economy goes into reverse, while the numbers out today, say, if you call 7% growth, if you believe that reverse that's a nice place to be. But nevertheless, they are selling down billions and billions of government bonds and that might be a thing that enables yields to drift slightly higher.

So, in my fund, the Global Macro Bond Fund, I still want to be underweight government bonds at this point, not just because rates are going up but also you have this big persistence seller of government bonds going forward.

Wall: I suppose then the flip of that is where do you want to be? If you don't want to be in U.S. Treasury bonds, where are the opportunities?

Leaviss: Well, if you look at what's been the worst performing asset classes in fixed income world, it's been in U.S. high-yield bonds and it's been in emerging market bonds. We've been heavily underweight in those two areas for a very long time, and because in emerging markets we've been waiting for the Chinese slowdown to come, haven't owned them. But when you see the Brazilian real is depreciated by 30%, 40%, the bonds are yielding 15%, 16%, 17%, and that's true across all of the emerging markets. I think that 2016 there will come a turning point when you say, actually the oil price was half from 100 to 50 to high 20s, is it going to go down to 12? It might well do, but nevertheless, there will be an opportunity in commodity bonds, in energy bonds and even emerging markets bonds.

We have Claudia Calich, who I know has been on here before talking about emerging markets. She works in my team and there will come a time, she reckons with two-thirds of the way through the sell-off in emerging markets, but hopefully there will come a time in 2016 where you want to pull the trigger and say, well, I'm not going to get double digit yields in any other bond asset class and this is the time to invest there.

Wall: Jim, thank you very much.

Leaviss: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar