Duration, Duration, Duration Is Warning Cry for European BondsAnchalee Worrachate and Katie Linsell
It’s debt-market math: Record gains in longer-maturity European bonds have left investors vulnerable to greater losses than at any time in decades.
With the European Central Bank’s purchases driving prices higher and yields down to unprecedented lows, investors are switching into debt as long as 50 years just to maintain rates they’re accustomed to. That’s added volatility risk to the horizon. Prices move more sharply relative to yields when maturities are longer and interest payments lower. The effect, known by bond wonks as duration, is headed for center stage.
European governments and corporations are locking in borrowing costs at historical lows. They’re finding buyers in a global debt market that’s unsure as to when the tide will turn and willing to accept price changes that will be magnified. Even junk-rated companies are selling longer securities and cutting debt costs. The risk is that their sparsely traded bonds can’t be sold easily when yields rise.
“When there’s a change in sentiment, it could be seismic,” said Henry Craik-White, a senior investment analyst at ECM Asset Management Ltd. in London, an affiliate of Wells Capital Management Inc., which oversees $357 billion of assets. “It’s a very careful balance, and if something upsets the apple cart, it doesn’t take much for people to panic.”
The effective duration on the Bank of America Merrill Lynch Pan Europe Broad Market index of bonds rose to 7.28 on March 20, the highest since at least 1997.
10 Percent Loss
Back to the math: Investors’ appetite for Germany’s 30-year government bond had crushed its yield to about 0.66 percent as of Thursday, versus a 10-year average of 3.37 percent. Now, if yields rise by 50 basis points over the next 12 months on that security, holders stand to lose about 10 percent, according to data compiled by Bloomberg.
The dynamic works both ways. Those same investors will earn a return of about 13 percent if the rates fall a half-percentage point by one year from now.
Buoyed by the ECB’s quantitative-easing policy, shorter-maturity debt has taken on its own shortfalls -- a German two-year note has a negative rate of about 0.25 percent.
“If we get a situation where fundamentals keep on getting better and the purchases are still holding down the yields, there will be some tensions in the market,” said Andrew Bosomworth, head of German portfolio management at Pacific Investment Management Co. in Munich. Pimco is a buyer of long-dated bonds, yet it warns that the market may snap when the ECB stops buying next year.
That scenario Bosomworth describes “implies it will pull the yields back up like a stretched rubber band when the ECB stops,” he said. “This is not going to be a problem for 2015, but it does warrant thinking about exit scenarios already.”
The Frankfurt-based ECB plans to pump 1.1 trillion euros ($1.2 trillion) into the region’s economy through September 2016. It started the program on March 9 and set out to buy 60 billion euros per month of government and private securities due between a minimum of two years and maximum 30 years.
The program helped to drive rates on more than a quarter of the region’s $6.3 trillion of government bonds below zero and pull long-dated bond yields to historical lows. Yet some investors continue to buy them for price gains, betting low yields will go even lower.
And they’ve been rewarded.
European bonds with maturities of 10 years or more returned 10.8 percent this year through Thursday, on course for the best quarterly performance since Bank of America Merrill Lynch records began at the end of 1985.
The thirst for long bonds has spread into corporate debt. Investors bought a record 95 billion euros of corporate securities maturing in at least 10 years during 2015, even as they’re getting paid near the least ever for the risk, according to data compiled by Bloomberg.
The average yield investors demand to hold the bonds dropped to an all-time low of 1.48 percent March 11 and was 1.59 percent, BofA index data showed on Thursday.
While company bonds maturing in up to one year lose 0.5 percent when the yield rises by 50 basis points, that loss increases to 5.6 percent for bonds due in at least 10 years, according to Bloomberg index data. Investors will earn 6.07 percent if the rate falls by the same amount.
“The longer you go, the more vulnerable you are to a change in the fundamental outlook,” said Norval Loftus, chief investment officer at Allegra Asset Management (U.K.) Ltd., which specializes in bond investments for large family offices. “Taking more future risk in a company that isn’t providing enough return to take that risk doesn’t add up to a good deal for investors.”
Coca-Cola Co., the world’s largest soft-drinks maker, is among companies that cashed in by selling long-dated bonds in euros last month. While the company’s 20-year securities pay 0.875 percentage-point more coupon than the eight-year notes, the risks are higher. A 50 basis-point yield increase triggers a loss of 8.5 percent in the 20-year bonds, and that loss is more than twice what it would be for the eight-year notes.
Bond yields may start rising well before the ECB finishes its QE program as the latest data suggest a decline in oil prices, a weaker euro, and low inflation are starting to benefit the 19-nation economy, said Luca Cazzulani, a Milan-based senior fixed-income strategist at UniCredit SpA.
Euro-area business activity expanded faster than economists forecast this month, signaling that a fragile recovery in the region is becoming more ingrained. While the threat of deflation remains, ECB President Mario Draghi has said that a sustained recovery is taking hold.
“While there may be more gains to be made in coming months, we are cautious about duration longer-term,” said Cazzulani. “There are already signs of green shoots in the economy. Yields could start rising way before the QE program finishes, depending on the strength of the data.”
The central bank revised its growth forecast to 1.5 percent for this year, from 1 percent previously. It predicted the economy may expand as much as 2.1 percent in 2017, a pace the region hasn’t seen since 2007.
Norwegian sovereign wealth fund chief Yngve Slyngstad said on March 13 that the fund was guarding against risks in the bond market by being weighted to shorter maturities, meaning it will stand to perform relatively better when interest rates rise. The fund said this meant that it lagged behind its benchmark in 2014 by 0.7 percentage point amid plunging yields.
“The value of these bonds is no longer determined by fundamentals,” said Salman Ahmed, a global strategist at Lombard Odier Investment Managers in London. “This is like playing musical chairs. The music may continue for a while, but there could be some trouble when it stops.”