The Bond Market Tightrope


Global share markets had a difficult time in June with the top 200 Australian shares by market capitalisation down 2.32%, property securities index down 0.84% and the global share index (in AUD) up 2.31%. The volatile market conditions were caused by several issues. There was an expectation that the US Fed will slow down its quantitative easing program, and the fact that stocks that had already risen over recent months could not sustain current prices in the absence of the US Fed’s help. Other issues in the mixing pot were concerns over the Japanese stimulus program, a potential slowdown of Chinese growth, and continued weakness in Europe.

Many commentators see the recent volatility as a short term reaction to negative data and announcements in an environment where longer term growth economic growth news and prospects are positive. And this is also our view. However, the same cannot be said about bond markets.

Bonds, or fixed interest investments (such as Government bonds), have for a long time been considered as defensive assets that do not lose value. The Global Financial Crisis (GFC) showed us that this is not true with US Government bonds and a speculative pool of mortgages effectively being classed under the same asset class even though they display a huge difference in investment risk. Luckily since the GFC these high-risk fixed interest vehicles are not as mainstream as was the cases before the GFC, however, challenges still remain in the bond markets due to the US Fed’s stimulus program.

 OK, we know that the US Fed has been printing money for some time, but how is this actually done? The US Fed is using quantitative easing to reduce long term interest rates and thereby supporting the close to zero short term interests rates that exists in the US today. This makes longer term borrowing cheaper for companies and households to kick-start corporate and household investment and spending.

By buying $85 billion worth of bonds each month bond prices go up (remember supply, demand, and the upward effect that high demand has on prices). And bond yields (or long-term interest rates) have an inverse relationship with bond prices – therefore as bond prices go up with continued purchases by the US fed, bond yields go down!

The issue is that the opposite is also true, and this is what can affect investors. As the Us Fed stops its stimulus program when they feel the US economy has recovered to an appropriate level of growth and ceases purchasing $85 billion in bonds on a monthly basis bond prices will fall (as there is less demand) and bond yields will go up; and this means that the capital value of a bond investment will fall with the investor experiencing a loss in the value of their defensive asset.

To negate this risk the VIP Investment Committee has been selling down the portfolio’s bond exposure, particularly in international bonds, and holding these funds in cash. We have earmarked to sell down the remaining international bond exposure over the coming period when conditions are suitable.