The media coverage around inflation has bordered on obsessive in recent months, with predictions of a bond market apocalypse and rampant inflation sending markets into a tailspin. The reality, according to experienced bond manager Jamieson Coote Bonds, is a little less hyperbolic, with its detailed statistical models now suggesting that inflation should peak in May this year. The reason, it suggests, is similar to that raised by central banks around the globe, being that the world is facing a number of secular trends which are highly disinflationary; poor demographics, higher leverage and now labour force “slack” chief among them.
According to experts, higher inflation would be the worst possible scenario for long-term or long-duration bond owners like Jamieson Coote, yet the team is welcoming the challenge, highlighting a number of issues that tend to be misunderstood by less experienced investors. Chief among these is the forgotten “carry and roll” strategy that has actually delivered the majority of returns to high-quality bond owners in recent decades, despite duration getting all the attention as interest rates fell to zero.
The comments come around 12 months after the group launched its JCB Dynamic Alpha Fund, which as the name suggests is seeking absolute returns from primarily highly-rated government bonds, rather than relative returns against the very-long-duration index. It was no doubt a bumpy start for a government bond strategy, given that it commenced in December 2019, just three months before the most volatile and testing period for fixed income markets in history. Despite the volatility, the strategy has returned 4.5% since inception and 3.7% in the 12 months to February, exceeding its index and objective return of the RBA cash rate plus 2.5%.
Traditionally seen as the boring part of portfolios, it is clear the opportunities for bond managers are heating up, with Australian government debt increasingly attractive to foreign investors but also seeing significant volume from algorithmic and CTA (commodity trading advisor) trading funds. The 3.6% fall in bond markets in February represented one of the worst monthly performances in the market’s history. According to the team, “the sell-off became self-fulfilling in Australia as the RBA did little to redress algorithmic and CTA-style funds continuously selling interest rates futures, causing longer-term holders to liquidate as the relative value of Australian rates cheapened against other cross-market nations such as the United States.” This starts to sound a lot more like equity market activity.
According to JCB, “almost everyone would tell you that bonds performed because duration rallied……but the vast majority of performance happens slowly in an accretive and continuously compounding manner of carry and roll.” By “carry and roll” the firm refers to the process where someone holding a five-year bond receives the “carry,” or income, of that security, but also the capital appreciation once that bond’s maturity becomes a year closer: the value naturally increases as the term-to-maturity falls.
This “normalisation” of the bond market, which includes higher yields and steeper yield curves, is likely to see the negative correlation between equity and bonds return in the coming months. As rates move away from the “zero lower bound.” JCB expects bonds will return to offer greater defensive characteristics; the issue, of course, is how the market gets there. This transition period is likely to be difficult for passive, long-duration or index-hugging strategies that have little flexibility, but a good opportunity for active managers.
On the outlook for volatility, JCB “cannot caution enough that this volatility will be very unlikely to remain in the risk-free complex,” or government bonds only, suggesting that investors in all asset classes should be wary. Specifically, there are concerns around the valuation of corporate credit, which is seen as “more expensive than pre-COVID-19.” The firm highlights the events of March 2020, when credit investments repriced, resulting in chaos and a loss of liquidity across the market. On the other hand, high-quality bondholders were able to sell and deploy into equity markets, adding significantly to returns.