Some bond managers uneasy as debate over bubble rages

The state of the fixed-income market has money management executives split, with some warning that bonds are in bubble territory and others thinking there is less need for concern.

Some investment executives think bonds are at an inflection point, potentially bringing more than three decades of a bull market to an end. Others are less convinced that this is the case, arguing that the underlying enemies of bonds are not strong enough to put the bull market into reverse.

The potential for a bubble was highlighted recently by the CFA Society of the U.K., whose members said in response to a poll in September that global bonds are overvalued. The proportion of those viewing government bonds as overpriced increased to 82% in the third quarter, compared with 75% in the second quarter and 67% in the first quarter.

Corporate bonds also are considered overvalued, at their highest level in three years of the society's index, with 78% agreeing the asset class is overvalued. That compares with 69% in the second quarter, and 58% in the first.

Sources working at money management firms said a combination of factors is fueling the debate around the inflection point. A rapid sell-off in bond markets, particularly in the U.K. and Japan, over the past few months is one factor. Another is the ever-louder call from all corners of the financial markets — including central banks — for the burden of stimulating economies to move to fiscal measures from monetary policy.

And then there's the bond rally of 2016.

“One of the reasons we are having this debate is fixed-income markets have had a tremendous year so far,” said Nicholas J. Gartside, London-based managing director, international chief investment officer, global fixed income, currency and commodities at J.P. Morgan Asset Management. “U.S. Treasuries have returned about 4.5%. If you think back to the start of the year, no one would have predicted that. German government bunds have returned 5.5%, and the (U.K.) gilt index is up nearly 12%. So even the most boring fixed-income markets have had a tremendous run, and that has crystallized a lot of concerns as we approach year-end.”

Profit-taking in bond markets after this performance is realistic, he said, and it is necessary to differentiate between tactical and strategic views. “It may well be that bond yields drift a little higher, and ultimately that is a correction, not a reversal.”

The reason for his hesitancy in declaring this an inflection point is that the two “enemies” of bonds — stronger growth and inflation — are not threats in the markets. “If you have both of those things you have an environment where central banks have to raise interest rates as economies are overheating,” Mr. Gartside said. “But when you look at growth and inflation, it is very difficult to say either of those is exuberant.”

Northern Trust Asset Management's David Blake, director international fixed income in London, said the firm doesn't believe bonds are in bubble territory. And even if they were in a bubble, he said he cannot see the pin that would pop it.

“It is all very well to say that valuations are high, but you do need a catalyst to turn that around. If something is going to reverse that, what? Is the Fed going to hike rates aggressively? No; we are not even sure they are going to hike in December. But we know that even if (the Fed does hike) there is not going to be another one anytime soon. Given our muted outlook on growth and inflation any hike is likely to flatten the yield curve,” said Mr. Blake. “We are not super worried. You would be, if you felt it was inevitable that it would turn around at some stage.”

Lucinda Downing, senior asset allocation analyst at Aon Hewitt in London, said while executives at the consulting firm believe the rise in the market's long-term inflation expectations is somewhat exaggerated, “we see the risk of a snapback in yields on the rise, given the possibility of more fiscal easing in the U.K. and globally, and a possible reversal to the overshooting of pessimistic U.K. policy rate expectations.” With yields so low, even minor changes in expectations could unsettle bonds. “However, it is not obvious that any such snapback will lead to a sustained period of rising yields.”

But pension funds need to keep hedging exposures. “We expect a slightly faster rise in yields than is expected by the bond market, but this difference remains inadequate to argue the case for pension schemes taking significant risk by not hedging their interest-rate exposure. Even without a snapback, such large negative real yields make bond market return prospects weak relative to equities and to a degree, even cash,” said Ms. Downing.

Investors' concerns are not unreasonable, added Paul Malloy, head of fixed income-Europe, at Vanguard in London. However, the firm continues to “believe that bonds remain by far the best diversifier for equity risk. Nevertheless, current low yields are unlikely to provide the same portfolio amplification as they have in the past.”

While BlueBay Asset Management LLP's house view is that it is too early to call a strong directional shift, the firm has been reducing duration risk across a number of strategies. The firm is broadly neutral to underweight duration across a number of strategies, “and that is because we do think that, at least in the short-term, we appear to have hit an inflection point in terms of this decline in core bond yields and rates,” said David Riley, head of credit strategy in London. That is down to a number of drivers, including the outlook for global growth and inflation being somewhat higher than three to six months ago.

Regarding whether bonds are in a bubble, Mr. Riley said the answer is both yes and no.

“It is a bubble in the sense that there is no economic rationale as to why you would buy a negative-yielding bond. The rationale for buying (those bonds) is primarily to do with regulation and holding liquid assets, and also to some extent liability-driven investment management. But is there a bubble in the sense of ... those manias whereby people drink the Kool-Aid and believe Internet stocks can only ever go up, U.S. house prices can never go down?”

Investors just “don't have a bubble-like mentality,” he said.

But others are convinced bonds are in a bubble.

“My view recently has been that we are in bubble territory,” said Jim Cielinski, London-based global head of fixed income at Columbia Threadneedle Investments. “It is a reflection of two things: where we are today, reflected in negative yields; and where we are going tomorrow. That is a function of expectations. The reason I think we are in a bubble is that expectations, both of growth and inflation, are extremely low as far as the eye can see. That is giving policymakers and the economy almost no credit to be able to reflate from these levels.”

He also said recent moves in the bond market are revealing. “We have had a sell-off — we shouldn't overexaggerate, but it was a material move, particularly in ... the U.K. gilt market.” Actions by policymakers, he said, will be key.

Managers at Columbia Threadneedle have been reducing rates exposure and also have seen more interest from investors in shorter duration strategies, said Mr. Cielinski.

Some managers are staying put when it comes to duration, but making moves at the margin.

Ben Bennett, head of credit strategy-active fixed income at Legal & General Investment Management in London, said managers have retained a bias to long duration given the weak growth and low inflation backdrop, but “we are tactically positioning for yields to rise in the very near-term.”

The firm thinks global debt is in a bubble — “it keeps growing, year after year, without an equivalent increase in economic activity. Interest rates keep having to fall so that borrowers are able to service their liabilities.” Because of this outlook, managers are underweight credit risk, given the negative implications of an over-indebted world for risky assets.

Market complacency is also a concern. Samantha Lamb, investment director at Standard Life Investments in London, said low- and negative-yielding fixed-income securities are creating an incremental demand for additional yield, and investors can achieve this by extending along the curve and owning longer-dated bonds, or moving down the quality spectrum and buying lower-rated credit. “In this environment the market can become complacent believing this type of incremental demand is a rising tide which will lift all boats. We believe this type of thinking will catch you out, that we're still seeing volatility in individual names and sectors,” said Ms. Lamb.

With inflation low across developed markets, Ms. Lamb said it's not yet possible to identify the trigger for a change in accommodative central bank policy, and “therefore we aren't positioning or trying to time the bursting of the bubble — as there is every possibility this low-rate, low-yield environment can persist for the next several years.”