Riding out the taper: how the Fed’s policies affect your scheme
Yields are rising as central banks look to extricate themselves from the markets, but 2014 may not be that simple.
Yields are rising as central banks look to extricate themselves from the markets, but 2014 may not be that simple.
As the new year rolled in, all eyes were on the global bond market. The US Federal Reserve began to taper its asset purchasing programme by reducing its monthly procurement of Treasuries and mortgage-backed securities to $75bn (£45.7bn) from $85bn.
It followed a tough year for bondholders, with Barclays’ Global Aggregate total return index falling in value by 4.4 per cent, according to data provider Morningstar.
Comment: Tapering reconnects investors with reality
One of the definitions of taper in the Oxford English Dictionary is “a thing that gives a feeble light”. Fairly appropriate, one might conclude.
Far from shining a piercing beam on the monetary road ahead, the taper announcement – replete as it was with conditions, qualifications and an offsetting commitment to an extended period of zero interest rates – just about lights the way to the end of the drive.
There is no consensus about QE. Commentators disagree on its effectiveness, when it should be stopped and whether it should have been undertaken at all.
Central to this wide range of views is the lack of relevant historical precedent, leaving analysts free to argue that QE is or isn’t inflationary, does or doesn’t stimulate the real economy and that its removal will or will not undermine the US economy and the markets at home and abroad that have or have not been beneficiaries of QE.
That said, what the Fed has done is reintroduce the hitherto suspended concept that financial markets should reflect economic conditions, not take their cue from a belief that authorities will not allow financial assets prices to fall.
David Lloyd is head of institutional fixed income portfolio management at M&G Investments
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But this long-awaited ‘tapering’ of the Fed’s intervention in the US huge fixed income markets did not trigger chaos.
“There wasn’t this mass panic or reaction,” says Peter Martin, head of manager research at consultancy JLT Employee Benefits.
There was a modest increase in yields, but this was down to the “fundamentals”, Martin adds. That is, one of the biggest purchasers leaving the market.
As the year moves on, the ability of the Fed to continue this trajectory while avoiding surprises will be crucial to whether bond markets keep a cool head.
“The volatility of the reaction will be the key,” observes Olivier Lebleu, head of international business at asset manager Old Mutual Asset Management. “If you have a relatively benign reaction, maybe [thetapering] is just a step function.”
Investment experts contrast the modest reaction in December to the reaction in May to outgoing Fed chair Ben Bernanke’s first hints attapering.
“A good outcome for UK pension schemes is exactly what happened in December,” Lebleu observes. “A bad outcome is an inflation surprise that no one had factored in.”
Investment experts have warned against a growing optimism that this year will provide the three elements of developed economy growth, gains on risk assets and rises in yields.
“I worry simply because it is a bit of a consensus,” says Ian Winship, head of sterling bond portfolios at BlackRock.
Growth in the UK and US could yet work to narrow the output gap – the difference between the potential and actual gross domestic product – and drive up prices.
“Inflation has not been out there for a considerable period so I understand why the market is a little bit more relaxed than it should be,” Winship adds.
How schemes are reacting
Some schemes are looking for shorter duration or floating rate strategies in order to deal with the uncertainties of the fixed income market.
Absolute return bonds and senior secured loans are being considered by consultants to reduce duration and protect against rate rises.
These instruments are often sought through a multi-credit investment fund that aims to give managers as much wiggle room as possible to protect portfolios.
Cambridgeshire Pension Fund has decided to invest in loans and absolute return bond funds as it looks to enhance its fixed income investments in view of the global economic environment.
“[The bond restructure was] designed to increase the overall level of yield and provide some protection against a scenario of rising interest rates and falling bond prices,” said the scheme’s draft 2013 annual report.
The derisking imperative leading many schemes is also forcing a lot more money into alternative forms of fixed income so that this allocation is properly diversified.
But other investment consultants have warned that boosting credit risk could increase the correlation of these instruments with equity markets and damage diversification at portfolio level.
In all the focus on yield, schemes are being urged not to ignore the impact of price inflation on their funding situations.
“It is not just about rising yields, it is about putting in place inflation protection strategies,” says Martin.
What next in 2014?
Those that said the yield lows of 2012 and early 2013 were a momentary blip have over recent months seen some support for their view.
“Markets have caught up with us because we were of the view that [it] had priced yields much too low,” says Tapan Datta, head of global asset allocation at consultancy Aon Hewitt. “There are quite a lot of [further] rises in yields already priced into the market.”
In the UK the Bank of England will play a critical role in this, with much depending on how its future statements to the market are received.
“The market is expecting [the] forward guidance to be modified because the last set of forward guidance was not particularly robust,” Datta adds.
The BoE had said unemployment would have to fall to 7 per cent before it would consider raising interest rates.
But this rate has fallen faster than expected, reaching 7.4 per cent in December, increasing the likelihood that governor Mark Carney will look to unpick the lock between unemployment and rate rises.