The Most Crowded Trade in Bonds Could Be Crumblingby and
Global government debt due in decade or more swells by record
Duration buildup creates vulnerability to interest-rate shock
The hottest craze in fixed income is at risk of overheating.
A headlong rush into higher-yielding, long-term bonds in recent years has created one of the most crowded trades in financial markets. Investors seeking relief from central banks’ zero-interest-rate policies have poured into government debt due in a decade or more, swelling the amount worldwide by a record $733 billion this year. It’s more than doubled since 2009 to about $6 trillion, data compiled by Bloomberg and Bank of America Corp. show.
Now money managers overseeing more than $1 trillion say the case for owning longer maturities -- stellar performers for most of 2016 -- is crumbling. There’s mounting evidence that inflation is starting to stir, just as some central banks hint that higher long-term interest rates may be the key to boosting growth. That’s troubling because a key bond-market metric known as duration has reached historic levels, and the higher that gauge goes, the steeper the losses will be when rates rise.
“Rates are rising from a very, very low base, which means there’s lots of downside and very little upside” for bond prices, said Kathleen Gaffney, a Boston-based money manager at Eaton Vance Corp., which oversees $343 billion. She runs this year’s top-performing U.S. aggregate bond fund and has reduced duration and boosted cash. “If you don’t know how to time it, and I certainly don’t, you just want to get out of the way.”
The lengthiest maturities have dominated the decades-long bull market in bonds, precisely because of their higher duration. Investing in 30-year Treasuries since the turn of the century has produced a 7.8 percent annualized return, compared with 4.3 percent for the S&P 500 index. Yet that run has faltered: U.S. long bonds are on pace for their worst month since June 2015, losing 3.2 percent as yields have climbed about 0.2 percentage point.
Only the longest-dated principal strips, the most bullish bet an investor can make in Treasuries, have fared worse. These securities, which have an even higher duration than traditional obligations, are down 4.9 percent in 2016, bludgeoning some of this year’s best-performing mutual funds. In a sign of the demand for this segment, the strips market has swelled to the largest since 1998.
Duration is at or near unprecedented levels across sovereign debt markets. The effective duration on Bank of America’s global government bond index climbed to an all-time high of 8.23 in 2016, from 5 when it began in 1997. The metric set a record 5.9 for U.S. obligations, 7.2 across the euro area and 8.8 in Japan.
That means the stakes are high: a one-percentage point increase in interest rates equates to $2.1 trillion in losses for global investors, based on a Bloomberg Barclays sovereign-debt index. That magnitude of yield swing isn’t necessarily a rare event. Benchmark 10-year Treasury yields have climbed by that amount over the course of a calendar year 10 times in the past four decades, twice as frequent as a 10 percent slide in the S&P 500 index.
“There were too many investors on one side of the boat,” betting that near-zero interest rates and central-bank bond-buying “were going to last as far as the eye could see,” said Bryan Whalen, portfolio manager at Los Angeles-based TCW Group Inc., which manages $175 billion in fixed-income assets. “This recent selloff, particularly in the long end, is kind of just the beginning.”
If he’s right, that may spell pain for investors who have already plowed cash into a slew of long-maturity sovereign sales this year. Ireland and Italy, which were caught up in Europe’s debt crisis, each offered bonds that don’t mature for at least 50 years. Thailand did the same. Last week, Saudi Arabia issued 30-year debt as part of the biggest bond deal from an emerging-market nation. Argentina and Brazil -- with junk grades from S&P Global Ratings -- borrowed for 30 years. Austria is said to be exploring the possibility of 70-year debt, according to a person familiar with the matter.
Belgium’s 100-year offering in April, with a duration of almost 47, highlights the risk. Just a one basis point, or 0.01 percentage point, increase in the bond’s yield would cost investors more than $6,000 on a $1 million stake, data compiled by Bloomberg show. That hasn’t been a problem so far. Issued at par, the securities are valued at about 134,794 euros ($146,831) per 100,000-euro increment, the data show.
While Belgium auctioned 30-year bonds at a record-low yield of 1.003 percent Monday, the bid-to-cover ratio dropped to 1.42 from 1.98 at a Sept. 19 sale.
Signals from policy makers are raising the prospect of a bond-market retreat. Federal Reserve Chair Janet Yellen this month laid out arguments for keeping policy accommodative, hinting at letting the economy run hot. Meanwhile, the European Central Bank has to consider how it wants to run its asset-purchase program. The Bank of Japan announced last month its plan to control interest rates to steepen the country’s yield curve.
“We have reduced exposures to duration in most major government-bond markets because of rising inflation and mixed signals from central banks,” said Christoph Kind, head of asset allocation at Frankfurt Trust, which oversees $20 billion. “Central banks, after a long period of disinflation, are going to tolerate higher inflation. That is not good news for longer-dated bonds.”
The U.S. consumer price index reached the highest in nearly two years in September. The 30-year break-even rate, a gauge of price-growth expectations, closed at the highest level since August 2015 at the start of last week. Across the Atlantic, both U.K. and euro-area inflation rates are accelerating.
Some bond bulls say they’re staying the course. Lacy Hunt, who helps steer the $447 million Wasatch-Hoisington U.S. Treasury Fund, said he sees rates remaining this low or even lower in the year ahead. That means he’ll stay long duration. The fund, which only holds Treasuries maturing from 2042 to 2046, has topped 99 percent of peers this year and during the past three, according to data compiled by Bloomberg.
Steven Major, head of fixed-income research at HSBC Holdings Plc, one of the Fed’s 23 primary dealers, said a year from now yields will be lower, and he doubts they’ll be higher in five years.
But as this month’s selloff shows, bond traders are getting nervous. The term premium, a metric that reflects the extra compensation investors demand to hold longer-maturity debt instead of successive short-term securities, touched the highest in four months after plunging to unprecedented levels in July.
Investors are no longer so sure of benign inflation that they’re willing to buy Treasuries with real U.S. yields near the lowest since the 1980s. When subtracting the level of inflation based on the core consumer price index, investors lock in a 0.11 percent yield on 30-year Treasuries, up from minus 0.1 percent in August.
Long-bond losses have “lots of room to run given the very low growth and inflation of the last two years seems to be shifting to a higher track for both,” said Mark Nash, head of global bonds in London at Old Mutual Global Investors, which oversees the equivalent of about $435 billion. He said he began shorting duration six weeks ago.
Progressively easier monetary policy “appears to be over in at least the near term,” he said. “So, sell bonds.”