“2014 will be both the Year of the Horse and the Year of the Bond”
Our prediction in the First Degree Long Horizon Absolute Return Fund’s Market Commentary, February 2014
And so it was! Very few market forecasters predicted positive returns for the Global Bond Markets in 2014, let alone that they would top equities, property or even cash. While Global Equities returned around 5.3% for 2014, Global Sovereign Bonds Hedged to USD delivered over 8.3% according to the Citi WGBI. This average includes all developed Government issues of one yr maturity and longer and therefore masks the stunning performance of long dated Sovereign bonds. For instance, the ‘super-long’ bonds, into which our Fund was invested, in Portugal, Spain and the US returned 53%, 36% and 22% respectively over 2014.
The simple reason for bond market superiority in 2014 was that interest rates fell across the board, and proportionately more at the long end of the maturity spectrum – a fact that most forecasters failed to predict. Forecasters tend to be economists (or graduates from the humanities), with very little finance training. Don’t mention term-structure theory to this motley crew since they will dismiss it as unnecessarily quantitative and missing the ‘big picture’. However, embedded within the term-structure of interest rates is the reason for 2014’s bond market triumph, as well as predictions for 2015. Let me elaborate…
First, term structure theory tells us that low interest rates are associated with lower rate volatility. The declines in global yields during 2014 suggest lower volatility in bond markets in 2015. Expect a quiet year.
Second, the risk premium in many markets continues to remain above long term averages, despite some contraction in 2014. Indeed, 2014’s bond market performance can be attributed to the growing realisation that interest rates are likely to stay low for a long time, and therefore the risk that rates will spike has diminished. This, in turn, reprices the risk premium that investors require to extend the maturity of their lending, and so the term structure has flattened. Nevertheless, the degree of flattening in the US, Spain, Portugal, Indonesia and the Philippines bond markets has not reached levels that are consistent with neutrality, so it is likely that these markets will continue to offer capital gains at longer maturities during 2015. Were we to rebalance the Fund today, we would be reducing some risk (‘taking profits’) yet remain overweight these markets relative to cash. The obvious exception to this general view is the German bond market wherein, with 10yr rates at 0.50%, is expensive and we would be short.
Third, credit turned in a lacklustre year in 2014, which surprised us, however this should be the big performer in 2015. High Yield bonds offer yields of 7% or more relative to 1.6% for similar maturity US Treasuries. A 5.4% risk premium compares with something like 3.5% over the long run net of defaults, so there is room for a 2% spread contraction in this market, which maps into total returns of 12-16% for benchmark indices during 2015. The market negativity that was present in the Sovereign markets at the beginning of 2014, but which ultimately capitulated during the year, continues to rule in the credit markets.
So our prediction for 2015 is that volatility will be low, longer maturity Sovereign bonds will outperform, and ultimately 2015 will be remembered as the Year of the High Yield Bond. Equities, eat your heart out but again…