Bond Market Issues and potential solutions

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Bond market issues and potential solutions


There are many worries with regard to the bond market and some of the investments that are held by many investment firms. In spite of all the concern, bonds generally have performed well since the sell-off a little over a year ago and year to date are performing nicely with the 10-yr note down to approximately 2.40%.


Bond, ETFs and mutual funds with longer durations have performed better than those with low or zero duration generally speaking as yields have come down significantly.


That solid performance has led many to deem the current conditions as a bubble or at least possessing stretched valuations. This places many firms in a conundrum since many investment policies mandate that there must be some allocation to fixed income. There may be many questions and concerns at this time in the cycle.


Given our reading and market observance we have compiled a short list of issues that may resonate in part or fully with your firm as you contemplate your fixed income asset allocation.


  1. Interest rates are low and anticipated to rise. Many products’ durations are high and a rise in interest rates would likely lead to a loss in principal.


  1. Low to negative real yields persist globally. Where are there pockets of value if any across the global debt markets? Many ETFs do not possess the nimbleness to be able to take advantage of the few that may remain. Would it be prudent to seek an active manager to replace some ETF exposure?


  1. Uncertainty with regard to inflation rates and the effect on bond market performance is a real concern. Is it time to shift some money allocated to traditional bonds and move it to inflation indexed notes?


  1. Spreads over Treasuries are tight by historical standards in many bond classes. It has become more difficult to find value. Spreads in some areas may remain tight but could tighten further or if conditions deteriorate, they may widen. It is important to have a flexible manager who is able to navigate these spread sectors.


We suggest that your firm dedicate an entire series of investment committee meetings to address these difficult issues to determine if a change is warranted.


In that effort, Zenith is happy to extend its assistance in a few ways. First, we are able take the time to discuss the various markets across the global bond landscape to share our insight as it relates to valuation, risk, potential rewards and outlook.


We are also ready to take an objective look at your current holdings and let you know our unbiased thoughts. This would provide you with an outside view to help facilitate a robust discussion that would either lead to a renewed conviction in your holdings or it could begin a healthy process that uncovers additional managers or ETFs that better suit your firm’s risk tolerance.


Finally, we are ready to present those managers who we believe are best equipped to handle the difficult road ahead in the debt markets. We not only look at their historical metrics but we also look acutely into their process. This is important as only those fund managers with a broad mandate will be able to add value in our opinion over the next few years.


Let us know if we can help your firm sort through some or all of these issues with regard to the ever evolving and challenging bond market.




Tom Koehler, CIO


Bond market danger?

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We have been reading a lot about the inherent dangers in the bond market given the low rates and the potential for interest rates to rise. While rates are low given historical spreads for most sectors, and the potential for higher rates both at the short and long end remains real, we will focus this brief piece on another risk that may be percolating.

Liquidity risk is the risk that the price of a security will not be able to be sold in the market due to a lack of interested buyers close to the current price. In a serious liquidity crisis, even high quality securities can lose value quickly before equilibrium is restored.

According to Simon Ejembi in a Punch article dated April 22nd 2014, The research department of the International Organisation of Securties Commissions said that, “Bond investors now face higher liquidity risk due to new regulation and interbank controls in the wake of the financial crisis.”

“Combined with the introduction of more transparency, this has made dealer banks to step back from their market-making role, causing a reduction in phantom liquidity. Bond investors now face higher liquidity risk as a result.”

The traditional inventory practice that is part of market making has been curtailed significantly by banks as regulations that curtail risk assets has dried up corporate bond market liquidity to a potentially dangerous level. listed an article provided by Seeking Alpha that delves into a couple major issues with regard to the bond market. Namely, the major source of liquidity has been driven by retail investors who have piled into bond ETFs and funds. A significant portion of these funds has been poured into big name products such as AGG(I-Shares Barclays Aggregate Index) and LQD(I-Shares Investment Grade Corporate Index).

However; as the article points out very importantly, the market’s structural liquidity condition has gone in the opposite direction. Dealer inventories of corporate bonds have plummeted by nearly 75% from pre-crash levels, meaning that the ratio of dealer inventories to bond fund assets has virtually been vaporized. In 2008 that ratio stood at 15%, but presently it is only 1.5%. Likewise, daily trading volumes have been cut in half since the crisis.

The abundant liquidity that the Fed provided caused a major mispricing of liquidity so that the liquidity premium generally ascribed to debt assets has been absent.

Basically this means that when the conditions change, the price for these bonds may be well below current levels. Considering many firms use these ETFs for their core strategic holdings, it is a very good time to examine them and to also talk to your mutual fund manager to discuss this issue.

We recommend choosing a manager who is able to price liquidity appropriately and to be able to build and manage a portfolio that holds proper nimbleness and liquidity.


Tom Koehler-CIO