'Duck and cover' is the new art of dealing with bond markets

Nevada National Security Site/Wikipedia (public domain)

It’s hyperbolic to suggest that bonds face a nuclear explosion. But in reflecting on the uncertainty of markets and politics, there may be some parallels to be drawn from the “duck and cover” protection advice offered during the 1950s and 60s.

Understandably, investors are aware that risks to the downside outweigh those to the upside and may be looking for places to find “cover.”

Let’s re-cap on where we are. Even before U.S. President Trump was elected, a reflationary trade had taken hold. His appointment seems to have turbo-charged already-buoyant investors who now firmly believe he will deliver growth to the U.S. economy. Having hiked once already, the consensus view is that the U.S. Federal Reserve (Fed) could raise interest rates three times this year. While we will unlikely see a return to pre-crisis levels of around 5%, the trend seems to point upward.

U.S. Treasury yields could follow the same trend. On the side note, we expect the Fed to raise 3.5 times this year, with half a hike (0.25%) coming from the upward removal of its current range-based rate. Taking away the range could be seen as a soft way of tightening policy, and one they utilized in reverse on the way down. Working against this optimism is the spectre of protectionism and a strengthening dollar. For now though, at least, the market mood is cheery, and that can be daunting for bond investors.

Government bonds could help reduce default risk, but because of the length of maturity required to earn any meaningful yield, they do little to reduce duration risk – i.e. the overall sensitivity of a portfolio to interest rate rises. Corporate bond markets can be more useful for addressing this. But even there, it’s a cautionary tale.

Politics, it seems, is destined to dominate thoughts, debates and investment markets. Impending elections across Europe are being keenly watched for any signs of populist success.

But technical factors will still play a role in driving prices. With central bank bond buying programs due to end in Europe and the UK, the demand side of the equation can begin to look worrying. In the five months to February 22, the Bank of England (BoE) bought £7.4 billion ($9.6 billion) of corporate bonds. In Europe, the European Central Bank (ECB) has bought €67 billion ($74 billion) since starting its corporate sector purchasing program in June 2016. This is all according to data from each central bank. As these schemes wind down, April for the Bank of England, and towards the end of the year for the ECB, proceed with caution is also the approach here. After all, large buyers will be exiting stage left.

The bond market rally has endured for so long that many credit investors have become complacent. This can be troubling, particularly given how many industries are going through upheaval.

One way of controlling some risks is by lending to companies who are heavily restricted in their decision making, either by regulation or by industry dynamics. Utilities and airports are examples of the former, whereas oil & gas, having already been through a consolidation and cost cutting phase, is an example of the latter. Securitized assets such as mortgages, properties or whole businesses, are another way of reducing risk as lenders are higher up the capital structure, and management is restricted on what can happen to the assets.

Another sector where the “proceed with caution” comes into play is the media and telecommunications part of technology, media and telecom (TMT). Vertical integration, consolidation of infrastructure, content production and content distribution have been key trends that could impact how businesses evolve to changing consumer wants and needs.

Merger and acquisition (M&A) activity is also something to watch closely. It can have profound effects on the attractiveness of corporate bonds. In order to close the deal, the acquiring company often uses leverage. This is typically fine if company management and economic conditions stick to the script. Leverage rises, only to fall back once cost synergies have been taken out of the joint entity. Yields rise temporarily to reflect this, then fall back down.

The theory seems clean and predictable, and priced in. But the reality is usually messy. The deal can fall through, can be executed poorly by management or economic conditions can conspire against profits and keep leverage high. Judging management’s form and track record is often a good indicator of whether or not a deal will be successful.

Uncertainty is not going away. We have always had to live with it, but staying ahead of markets seems harder than ever. That is why finding cover in the traditional places may no longer get the job done. In other words, we are moving toward less traditional bunkers to find cover.

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