So we continue to live through historic times.
Despite spiralling debt and huge Govt supply to reduce deficits, Core Govt Benchmark (UK and Eur) yields continue to fall and dumbfound and perplex many market participants.
It is worth looking at this interesting Article by Chris Dillow 2010 that appeared in the Investors’ Chronicle on the effect of Supply to Yields Debt and Gilts-some History
The question is, are we, like the Vapors 1980’s hit single “Turning Japanese”?
This Commentator has lived and breathed Fixed Interest markets since 1986. A period when, as a Market Maker in UK Gilts, “Shorts” (up to 5 yrs) had maturities such as 10% 1989, Cv 10% 1991, “Winnies” or 13.5% 1992…… and “Mediums” had coupons of 14% and 15 % with the longest gilts including deliverables of 13.5% 04/08 and 11.75% 03/07. You don’t imagine that you will see the bonds mature let alone a market such as this when they do.
I developed my understanding of RISK from people who was saw the unthinkable where Yield and Price crossed at 17.00 in the undated Consols 2.5%. Surely a mathematical impossibility (ie: Yield> Price)?….but it happened. Nowadays, high yield probably means circa 6% if your lucky with only a A rating or less? The question is staring us in the face……
Has the search for Income and Yield gone too far?
Many funds with available flexibility have been pursuing Equities and “dividends” as their method of Income ( Ftse Large Cap +16% YTD while the broader Ftse 100 Index -1% YTD). Could it be that a defensive flight to UK Gilts and German Bunds from the peripheral tainted Euro Economies of Portugal, Italy, Ireland Greece and Spain is falsely accelerating lower yields in the higher quality paper?
This is speculation on our part, which we leave to the Economists who have the luxury of always being right …………”eventually” but this does not help the real life money Managers. At the moment we see their concern, they are correctly worried about using Fixed Interest for Income purposes but are becoming increasingly concerned about the growing risks of capital losses.
Here is where we currently stand: The Table below shows the current state of the Benchmark Govt Yields & Yield Curve Segments and the Historic Change in those Yields and Segments:
Fig 1 a Govt Bond Yield Curves and Segments
I dont know whether we are heading for deflation, do you? ….. Our approach is to consider the evidence, looking back to try and learn from History…….and quantify some aspects of the “Risks” in our current situation.
- The biggest 1 day “Shock” to the UK Gilt Curve was on the UK departure from the ERM where on that day 5 yr Gilts went UP in price by 5 big figures at the same time when 10 yr Gilts FELL 1 big figure (which translated into a shift of nearly 90 basis points DOWN and ten basis points UP for maturities that were only 5 yrs apart). For those unfamiliar with fixed interest this was a crunch that you could not predict and very painful if you were caught in the process.
- In 2008, Fixed Interest 30 Day Historic Volatility rocketed from its normal 5% – 8% range to exhibiting almost Equity like volatility of 15% – 25% and stayed like that for 2 months.
- Digging deeper, 2008 1-Day Annualised Volatility in UK Gilts (i.e. the therotical 1 day % move that you might reasonably expect) trebled from 0.70% to over 2.00% per day, every day.
This was one of the key reasons why many Value-At-Risk (VAR) models broke down, leading to a higher than normal amount of “stop losses” being triggered and worst of all capital losses realised, even in what were considered “safe instruments”.
The above factors are included in the drivers of our proprietary models and are the basis of our reports. As we stand, it looks like it could happen again, so if you are mis-matched, holding longer term bonds for shorter term income, the question is:
How many years of income will it take for your Client to make up a 10 or 20% capital loss that will result from increasingly small changes in the yield curve?
Apart from a few short sharp shocks since 1992, yields have continued to fall. Imagine the cost to these Govts if they were borrowing at 1990 levels? No wonder they are issuing 50 yr and 100yr Gilts now. But then again, maybe they will use some of the proceeds to Buy back the Gold Reserves they sold off at below $300!
The Sinergi Solution
Sinergi have advanced their proprietary financial models by using Qlikview patented “associative search” functionality. This allows us to quickly consolidate large amounts of disparate data sets to memory and to format and present this data as meaningful management information in the form of , what we call ” Sinergi Dashboards”
Fixed Interest V’s Equities
The next question is: Is it right to Buy Equities on the basis that Fixed Interest “appears” to be expensive? Lets see if they actually are? and look at the following:
Fig 2 (a) Dax 30 Vs Bunds
Regular visitors to Our Blogs and Research will already know that we are not concerned with the sole analysis of an internal price relationship to determine whether something is “cheap” relative to its historic price. At the risk of stating the obvious, something that is relatively cheap can continue to be even more relatively cheap in the future. What concerns us is the prospect for a change in the price trend and the nature of the “Risk” that is attached to that instrument and alternative comparable opportunities.
Using Sinergi’s Proprietary Risk modelling, we can see that Fixed (10 yrs) is currently neither expensive OR cheap when compared to Equities (in risk terms). So What do they look like in isolation?
Fig 2b German Bunds (Weekly)
Again we are not interested in Selling High Prices alone. We focus on identifying “Risk” attached to any price. The Chart above shows that despite approaching new high prices we have NOT YET got the Signal to act in any particular manner.
Hot off the press, we are providing snapshots of our Dashboards and the filters as we apply them to focus on our subject, the relative attraction of Equities compared to Fixed Interest.
Sinergi Dashboard (Qlikview) – Equities
Sinergi Dashboard (Qlikview) – Fixed Interest
It is important to note here, however, that your motivation for holding an investment can be a significant influence on your actions. For example, if you have matched a liability to a particular Yield duration then , frankly, you don’t care what happens in the short term as long as the credit risk of your counter party is not affected.
However, the possibility exists that a “bubble” bursting in a duration or maturity of Bonds where there is a mis-match between Income and Capital Risk (eg see 5 yr V 10 yr gilt example above) could have a devastating impact on capital. Importantly, the “crack” could come in any part of the Yield Curve.
Clearly, for us the rational line of thinking is that the risk of loss in yield versus capital preservation in terms of moving to cash is now minimal and an acceptable. Achieving this will only be clear if you are managing bond investments directly yourself and you have the ability to match your liabilities effectively. But if you have outsourced your management solution to a DFM you will not know what Fixed Income exposure and to what duration you have …………………until its too late!
History is full of examples of seemingly “safe” instruments/ Institutions that have blown up in our faces. We can not say at the moment if or when this will happen but we can see the situation forming for such an event. We are now sitting tight and waiting for our own action points. However, with your lead times in place it will be worth considering here. There is NO such thing as a free lunch, such as yield without capital risk.
So, Protect your Clients’ money. Go and find out your Clients’ fixed interest exposure……..NOW!!
To learn More about Sinergi Dashboards that operate in Real Time please join one of our upcoming Webinars Here