Inverting yield curve dogma

Short rates have gone up in the US. Longer rates less so. The yield curve has flattened; is flattening; and conventional wisdom has it that this will continue. In due course, short rates will yield more than long rates. Think of, for example, two-year bonds at 3% and 10-year bonds at 2.875%. No problems with the maths, but does it mean anything?

The second part of that conventional wisdom is that as the yield curve inverts it is the amber light for a forthcoming slowdown. However, unlike the amber traffic lights which are typically set at five seconds, there is no predetermined time after which there has to be a recession, indeed if it all.  It could be a year (as we saw in 1990) or many years (as we saw in the late 1990s). That is the stuff for bond fund managers’ debate – but there is a determinism here. What if the patterns over the past hundred years are wrong? What if it is different this time?

Enter analysis from BNP Paribas. Its research shows that up until the 1930s the yield curve was almost always inverted (i.e. it’s not different this time, it’s just that we haven’t seen this for a long time!) Perpetual Gilts traded at a premium to short dated “call” money. It is worth thinking of it like this: Those people who had money didn’t want the hassle of chasing higher yields from the lightly regulated banking system. Stay safe with Gilts and let those who really needed money squabble for it at higher yields. No doubt a simplistic view of the materially less regulated world of late 19th Century bond markets, but there are parallels with today. Regulation demands that a whole chunk of pension fund money is locked away for the long term in safe assets almost irrespective of the cost of “call” money, which is creating ( as we have seen many times and continue to see in long Gilts) an inverted yield curve.

So why debate this now? The Fed is spending a lot of time worrying about what an inverted yield curve might mean for expectations as well as economic reality. As the graph below shows: the pre-1930 world was far choppier in terms of recession and expansion.

US Yield Curve Versus RecessionsSource: Macrobond, BNP Paribas

Todays’ sophisticated world of central banking and generic 2% inflation targeting provides stability; but as Quantitative Easing stops and the unwind drips the stock of bonds back to the market we are in unchartered territory. It might just be a little too easy to assume an inverted yield curve means upcoming recession.

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Beautiful inside my portfolio forever

It has been 10 years since Damien Hirst sold 233 lots at Sotheby’s raising $198m – entitled “Beautiful inside My Head Forever”. The sale was conducted on September 15th & 16th and the timing proved an odd counterpoise to the destruction and collapse in financial markets. It helped highlight the surreal nature of financial markets when compared to the “real world”.

To prove to the art world that financial types don’t, well, understand art, I thought it would be useful to compare how Hirst’s art had done compared to the global high yield bond market. As even us financial philistines know – there is no visual pleasure in ownership of a high yield portfolio, but there is in Hirst’s dots or sharks.

Here’s the back of a pharmacy cabinet analysis. Hirst’s $198m put into the global high yield bond market would have more than doubled over the last 10 years – let’s call it $400m bar the shouting. A Google search of Damien Hirst’s price index shows a peak prior to the financial crisis and values are currently around one third of those in 2008. Hirst’s $198m sale would now, in theory, only raise in the region of a paltry $65m.

So I guess that’s asset allocation for you, or simply the power of carry. Or maybe the moral is to be a rich philistine or a poor artist. Or alternatively be Damien Hirst.

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World Cup Picks ‘n’ Pans

Excitement is brewing as the World Cup begins today in Russia. Here are the Kames Fixed Income team’s top 5 picks for the tournament.

World cup ranking (1)
The ultimate tournament team – serial winners and current holders of the cup, they have a knack for peaking at exactly the right time. A blend of youth and experience should see them progress but with the fitness of “sweeper-keeper” Manuel Neuer key. Germany’s credit quality is rock solid but the end of ECB QE will mean some caution is required…
World cup ranking (2)
The nation has won the most World Cup tournaments, but suffered a humiliating 7-1 defeat by Germany in the last tournament’s semi-finals. The South American side will be out for revenge. Despite positive momentum for the World Cup, the outlook for bonds is not as constructive as the country tackles strikes, a weak currency and upcoming elections.
World cup ranking (3)
The side is teeming with youthful talent but lacking that much needed experience. Despite this, a successful coach and strong team morale on the back of second place at the Euros in 2016 should see the team do well. Meanwhile, since the election of Emmanuel Macron in 2017, French debt has been very popular and has performed well.
World cup ranking (4)
Probably Lionel Messi’s last shot at the competition he has never won, but Argentina’s preparation has been chaotic, including a 6-1 loss to Spain in a warm-up friendly. Meanwhile, at home the country is also in chaos and has had to call on the IMF for support. This could work out in bonds’ favour, at least until domestic politics intervenes.
World cup ranking (5)
A fresh team of quality players (and extremely new coach) have emerged after a disastrous Euros in 2016, however we think the team are a few years early for a World Cup win. For bonds, the market is long Spanish risk and political risk is increasing again. Better quality is available elsewhere in Europe.

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Kames Wags ESG Axe

For those wanting to find out what fund management is all about, don’t watch “Billions”. However, ever of the moment, Season 3 Episode 9 sees Taylor Mason pitch to a Russian oligarch, Axe Capital’s first foray into an ESG strategy. 29 years behind Kames, Taylor…

The screen plot, nonetheless, aims to emphasise tension between Taylor and Bobby Axelrod; Taylor does have a point when saying “I think international criminals are unstable bedrock for a cap raise”….

But it does raise the question who should want an ESG approach to funds and indeed what that ESG approach should be. There are added complications for fixed income investors too; no voting rights and benchmark parameters for starters. So to make Showtime’s scriptwriter’s life easier I have written Taylor’s script for how she should pitch ESG next time to John Malkovich, the Russian oligarch or one of his henchman.

“First, break a habit of a lifetime and obey some international government rules and don’t buy companies that make cluster munitions. In the words of our President, Bad! Anyways we can do better than that.”

“Second, you value your health, right? So don’t finance the black stuff. No oil: we don’t want you breathing too much Co2. Oil companies are out.” Oligarch squirms to consider the source of his ill-founded fortune.

“Third”, Taylor adds, “We can use algos to screen for bad companies. I’ve selected the best team to analyse ESG factors. These guys are winners.” [In this episode Taylor selects crack computer geeks to do “bad” things in equity market quant strategies. Let’s use our imagination and think they might be able to effectively screen ESG factors – something we have struggled with given the data quality]

“Fourth, and if you really care about ESG,” Taylor looks emphatically into the eyes of the now seething oligarch, “we incorporate it into what we do. No analysis without thinking how these companies are managed. We’ll figure out how they impact their workers, their customers. Are they damaging the world? If you want to do good you need to think about this. Are you with me?”

Taylor finishes “We want you to invest and deliver sustainable development goals….” at which point the Russian oligarch blows: John Malkovich at his malign, evil, sphinx-like best smashes his fist on the table and screams “What do yooooou take me for…?”

Of course this is all a bit surreal but it does display the various ESG approaches potentially available. We are firmly in the camp of bottom up research for the ESG investment process – and not being John Malkovich.

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Poor PreferencESG

Preference shares took centre stage on the financial pages and Aviva press cuttings during March. It looks like we haven’t seen the end of the shenanigans with reports of further FCA digging. So what was all the fuss about?

Firstly, a bit of relevant background. These preference shares look like a bond (pay coupons) but have no fixed maturity i.e. are irredeemable. They also look like equity, carrying voting rights. Issued back in the early 1990s, at the time they added to the capital of the issuer and have traded like ultra-long bonds. Indeed as the instruments were issued with dividends (coupons) in the ball park of 8%, it is no surprise they have traded materially above their 100 issue price. The Aviva 8.625% bond was trading at 175 before the Aviva announcement.

So why did Aviva make its proposal to cancel these preference shares? Since the financial crisis there have been myriad changes to banking regulation and one of the outcomes of this is that these preference shares are not as useful as they were in counting towards capital as set down by regulators. Thus, Aviva, not unreasonably, sought to figure out how it could redeem the irredeemable preference shares.

Nothing wrong so far except for the plan. The plan proposed was in essence to amalgamate the voting rights of ordinary shareholders with those of the preference shareholders, ensuring the preference shareholder voice was drowned. Or put another way: propose a legal scheme by which the small minority (the preference shares) who are receiving those 8.625% coupons are made to vote equally with the vast majority of shareholders, who are in essence paying the 8.625% coupons. Good for ordinary shareholders because the proposition was to buy the preference shares back at 100 – where they were issued over 20 years ago – rather than the current market price of 175.

Even more succinctly, the scheme proposed a compulsory property purchase at 1990s prices (100) rather than today’s price (175). How could that “clever” scheme have been proposed? Who thought that that could be a good idea for ALL stakeholders? Forced appropriation of assets at below market price isn’t the stuff of equitable governance. No wonder there was uproar; the proposal had all the hallmarks of inward looking self-interest and absence of broader scrutiny.

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Watering down tax structures

On 28 July 2010, the United Nations General Assembly explicitly recognised the human right to water and sanitation. It will also come as no surprise that in the UK we have enjoyed clean water for generations. Investing and supporting companies that deliver clean water certainly falls into ESG investing.

However, ownership of the assets that deliver water and sanitation has become political in the UK. As investors in bonds issued by water companies, we are keen to ensure that we maintain the value of our investments. There are three strands to our analysis. First is the effective management of these companies. Second, is the ability to reinvest in assets to deliver future cash flow and returns. Finally, exploring the social, regulatory and political environment in which companies operate.

It is this very last point that has recently become more material in our assessment of the UK water companies. At the start of February the Social Market Foundation issued a report claiming that the nationalisation of the water industry would cost in excess of £90bn. Water and its ownership have become a political issue; the election campaign in 2017 saw the Daily Mirror run this headline: “The Labour Party claims the water industry has been used for tax avoidance and says it’s time to bring it back into public ownership”. The use of offshore tax structures have become a political issue for an industry that has spent, and needs to spend, billions investing and delivering water in the UK.

Our fixed income team, together with our ESG-research team, has penned a letter to a number of major bond issuers in the UK water sector. We wrote that the nature of delivering clean water infrastructure requires further investment but that past and future investment should be conducted in a tax framework that, in itself, gives confidence to the public as consumers. There was no accusation of tax evasion but that certain efficient tax structures are not publically acceptable in times of strained public finances. We wrote that “Perceptions of what is acceptable have undoubtedly changed in recent years” and encouraged issuers to review tax structures that offer the perception of “cute” financing arrangements.

As investors our responsibility remains to the value of our investments. As such, and as our letter stated, “It is our responsibility to balance any reputational issues that adverse publicity may create within our overall risk assessment”. The rights and merits of public or private ownership are not ours to judge, but where we can influence to reduce uncertainty and volatility in the value of our assets, that is in our gift and interest.

Transparency builds trust and goodwill with all stakeholders (including investors). We hope that in some small part we can encourage transparency in how the companies we invest in manage their arrangements and in doing so, ensure effective delivery of water to all in the UK.

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Five things to remember from 1994

The bond market’s memory is arguably short, but 1994 remains vivid as the last time that interest rates were raised in an aggressive, systemic fashion led by the US Federal Reserve.  The effect was dramatic with a near doubling of 2 year Treasury yields to over 7.5%, with Fed Funds moving to 6% from 3%.

Here are some other facts from 1994 that still reverberate today.

1) Amazon was founded in 1994. Now with a market capitalisation of $700bn, it has had a huge impact. It has disrupted and undermined traditional market assumptions across a whole range of sectors from real estate to retailing. As a barely profitable organisation it has grabbed huge market share and decimated inflation.

2) Lehman Brothers was floated having been spun out of the Shearson Lehman Hutton combine. In under 15 years Lehman’s aggressively leveraged balance sheet collapsed with spectacular results, ensuring the rapid dismemberment of its $680bn balance sheet in a disorderly fashion.

3) NAFTA was signed in 1994. Even if it isn’t completely revoked it is viewed as helping Donald Trump to the White House. The politics of around a fifth of US cars in effect being produced outside the US lingers, despite a fourfold increase in overall trade and an ongoing cap on inflationary pressures in the US.

4) US Debt. The US Budget deficit in 1994 was 2 1/2% of GDP; and outstanding US Treasury bonds totalled a rather paltry (by 2018 standards) $4.6trillion. Fast forward to 2018 and the Federal Reserve alone has amassed almost that amount of bonds for its Quantitative Easing programme. The amount of outstanding Treasury bonds has quadrupled whilst GDP has only doubled, leaving debt to GDP double at 100%.

5) None of the above takes away from the dramatic market sell off in bonds during 1994. An index of the treasury market would have lost almost 3.5% in total with most of the damage being done in the first quarter of 1994.

Market participants rightly fear a return of such bear sentiment, but a rerun is not on the cards.

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Video: Carillion and other areas of the market investors should be wary of

Adrian Hull and Stephen Snowden share their views on Carillion and other areas of the market investors should be wary of.

‘It’s obvious that retail is going through a very difficult period of time and will continue to do so. The internet has just killed traditional retailing as we know it and the pressure will only get worse.’

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Video: A view from the US

In this short video, Adrian Hull discusses the outlook for the US market.

‘Certainly a lot of people think there will be a material repatriation of overseas assets for US corporates which will feed in to the US economy…’

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The small print view of 2018

Life as a journalist covering fixed income is usually easy in January. They will wheel out last year’s article about the imminent collapse of bond valuations and head off to the pub or the gym. If you are lucky you will get a Bill Gross soundbite for a headline! This year has so far been no different, and the Kames fixed income team is keen to avoid such hyperbole and instead offer a more grounded and realistic viewpoint. So, what do we expect?

Government bond yields will continue to remain low but the most likely outcome is that they drift a little higher in 2018. That is likely to be true across all the major markets. Today, 10-year US bonds are at 2.65%, 10-year gilts at 1.35% and 10-year bunds at 0.57%. Fixed income, like all markets, doesn’t move in a straight line, but we are most likely to be managing rates risk within portfolios, anticipating that we could see 3% on US 10s, 1.6% on gilts and potentially up to 1% on bunds during 2018 (mindful that along the way yields may well be lower than where they are today). As active investors we will change exposures and there is a fair chance that 31 December 2018 does not represent the highest point in yields.

What does that mean for short rates? We think it is unlikely that short rates head higher in the UK or Europe. That is most likely a 2019 event and the UK has to deal with the headwind of Brexit. European economies fared better in 2017 but will want to cement their growth path before looking to increase rates. As we have seen from the US, the rates path is slow and shallow. We could see further rate hikes in the US and the market anticipates between two and three increases of 0.25% in 2018. Inflation is set to remain tame by recent standards; US and European inflation could nudge up towards 2%, while UK inflation is likely to retreat from RPI above 3%.

The majority of our assets in fixed income remain invested in credit markets. Credit markets performed well in 2017 and it is unlikely we will see that same level of outperformance in 2018. Nonetheless the extra carry and returns from actively managed portfolios will add performance, and we hope to do better than just the coupons received. We have noticed an increase in events that have the potential to unnerve credit markets, but currently they have only gently rippled into sentiment. We start the year more mindful of that risk, but without a dramatic change to how portfolios were positioned before Christmas.

Each year there tends to be an event that gives us the opportunity to change our risk profiles and add to performance. Having said that, the most exciting opportunity in 2017 was early in the year during the run up to the French elections. 2017 was atypical and our expectation is that we see some events creating more material volatility in 2018. For example, that may be around the Italian elections in spring. Or a further reduction in bond purchases by central banks could inject material concerns into markets. Tax reform in the US could change some behaviours. Other geopolitical events may add to volatility. The current tentative rapprochement on the Korean peninsula may be short lived. Iranian politics could spike oil prices. Eastern European politicians may be less willing in EU plans than currently indicated. There are a host of challenges and the chance is that none of the above capture the market’s imagination but other factors do. We continue to endeavour to be ahead of events.

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Not the South Sea Bubble

Christmas allows the opportunity to pull a book off the shelf and read. This year’s thriller was “The Great Swindle” a dated (1960) historical account of the South Sea Bubble.

It’s all in there for today; credit, greed, hubris and collapse. Winners and losers. A number of parallels caught my eye. Back in 1720 there were many “bubble” sceptics and these included Britain’s first Prime Minster, Robert Walpole and the then Archbishop of Dublin who wrote “..I am not concerned in it, for I think, if the debts of the nation may be paid by th[is] folly…it will be very well for the public”. Indeed, many felt that the transfer of the public debt burden onto individual stock holders was a good thing. No need to go into the particulars of what the scheme was, but in modern day parlance it was a “debt for equity swap for UK plc”.

Skip forward almost three hundred years and many of the debates of the 1720 are today’s debates, but in reverse. Today, it is generally accepted that government debt issuance to fund the state is a good thing – the exact opposite to the purpose of the South Sea Company. One of the overriding structural changes of the last ten years has been the transfer of debt from the private to the public sector. Today’s balance sheet increase – QE – has its critics, but few argue that that response didn’t soften the impact of the 2008 recession.

South Sea led to asset price inflation as those who profited and exited South Sea investments bought carriages, houses or land. A similar comparison could be made of asset owners over the last ten years, who are seen as having benefited from QE and zero interest rates. Today’s zero interest rates has impacted materially savers solely reliant on negative real return deposits.

The South Sea Company proved to be a get rich quick scheme despite the veneer of Parliamentary respectability seeking to reduce the country’s debt burden. The timeline of today’s ZIRP is in stark, prolonged contrast and very different to the flash in the pan of 1720. Wiser punters such as Sara, The Duchess of Marlborough saw that “this…project must burst in a little while and fall to nothing”. Whilst Walpole stabilised the South Sea bubble in late 1720, it wasn’t until 1733 that the Company was divided up and over another hundred years before South Sea successor companies closed. Maybe an interesting thought to the timeline where by QE is unwound in today’s G7 economies?

At peak valuations in 1720, the value of the South Sea Company was more than the total of Great Britain’s national debt at £50m, and GDP at an estimated £64m. It makes the UK’s asset purchases of £435bn by the end of 2016 – being a mere c.25% of GDP – look rather tame by comparison. Both post 2008 and post 1720 the issue of the day was stabilisation and dealing with deflation caused by bubbles.

So what does this all tell 2018’s investors? If there is a bubble out there, likely it’s called Bitcoin or tech. Bitcoin, like tech stocks, offer exciting chances of betting on a new, different future – much the same way as the South Sea Company did in 1720. But more pertinently it’s not the bond market. Whilst government bonds most likely drift higher in yields in 2018, it’s not a bubble – there will be more to worry about elsewhere.

 

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G stands for Governance not Green

The explosion in demand for green bonds in recent years has left them looking expensive versus other fixed income securities, with better options available to investors outside this niche part of the market.

Over $100bn of green bonds have been issued so far this year, with the euro-denominated market leading the way after accounting for 43% of all issuance. Investors have been attracted in their droves to green bonds, with market conditions exceptionally favourable for the securities over the past 18 months.

As a result, issuers have generally been able to dictate the terms of new debt and thus rush to create green bond structures. The sector has become overvalued as a result.

We do not want to ruin the party, but we choose to avoid buying green bonds due to current pricing. Where an issuer’s long-term ability to pay is not backed up by the right business model or balance sheet, adding a green moniker to that issuer will not make us invest.

Investors must consider green bonds within the wider context of ESG, and ensure they drill down into the underlying drivers for each bond, rather than focus simply on the notion that they have some level of green credentials. In particular, investors need to be aware that the underlying risk from green bonds is not ring-fenced from other debt the company may have issued.

Our belief is that green bonds should be treated much like any other anomalies; we will seek to exploit them. Where we can lend to an issuer for the same length of time, with the same security, and support a green project – that is great. But we are not in the business of lending money to the disadvantage of our portfolios and clients where the cash raised by those issuers is fungible with the rest of their cash pile and our security is ranked along with all their other debt in the issuer’s general corporate purposes.

Green investing should be actively encouraged, but not at prices or in companies that could otherwise not pass investment scrutiny. A strong business model and good governance are key to our process and ESG success. That ‘G’ stands for Governance, not Green.

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A green opportunity, but at what cost?

Green bonds have grown in prominence over the last couple of years, with a company’s ESG (Environmental, Social and Governance) credentials assuming ever-greater importance for investors. The terminology used to describe green, or ethical, bonds – and the definition of investing ethically – can often be interchanged to such a degree that the end investor is left with an incorrect understanding of the difference, and perhaps a lack of appreciation of the risks.

Dedicated green or ethical bonds are sometimes issued by established blue-chip corporates (e.g. Lloyds and SSE have issued green bonds in recent times); the proceeds of such issuance is essentially ring-fenced by the issuer to fund socially responsible or environmentally-friendly projects. Liquidity in instruments issued by such well-established entities is typically as deep as would be the case with the rest of such an issuer’s capital structure.

Unfortunately the same liquidity is rarely as prevalent in green bonds issued by unlisted entities, regardless of how “green” the opportunity may be. The substandard issue size of such bonds (very often less than £100m outstanding), combined with the lack of disclosure limits the scope that such bonds can be bought or sold in the secondary market. It is this trade-off between maintaining liquidity in an investor’s portfolio, whilst maintaining their overarching desire to fund responsible and environmentally-friendly businesses that perhaps deserves greater attention than it is given.

One avenue that facilitates an efficient combination of the dual requirements of investing ethically without compromising liquidity is to invest in an ethical fund. At Kames we have managed ethical portfolios since 1989, with an independently administered “dark green” screen in place to ensure that the portfolio’s investments are consistent with the expectations of our client base. The end investor has regular disclosure on the nature of the fund’s exposures, whilst they can also sleep well in the knowledge that their investments have daily liquidity.

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Why a disorderly queue is worse than an orderly QE

The UK’s reputation took a further plunge as investors queued outside the Bank of England yesterday (see below) demanding payment in either gold or other hard currencies in exchange for the pound.

The currency took a further lurch lower in value after another frantic day’s trading on currency markets. Following the Governor’s refusal to bail out the UK’s major banks in 2008, the UK has failed to break from its cycle of recession after the catastrophic effects of the collapse of an effective payment system in 2008. The subsequent widespread economic hardship was exacerbated by The Bank of England’s refusal to allow Quantitative Easing (QE). The policy of QE has been aggressively pursued by other major central banks since 2009, leaving the Bank of England an outlier. The European Central Bank incrementally added its QE programme which saw a rapid solution to its “Euro crisis” in 2011.

This scene from yesterday, outside the Bank, is reminiscent of Northern Rock’s collapse 10 years ago, which saw then Chancellor Darling bail out that bank, but encouraged him and the Prime Minister to not support further bank rescues in 2008.

Yesterday’s demand was from a disparate collection of private individuals and investors, and marks the further increase in tensions as the currency slipped to further all-time lows against both the dollar and euro. As overseas investors continue to shun the UK government bond market, double-digit gilt yields further undermined equity market confidence.

Last year’s vote to leave the European Union only exacerbated the already weak financials. Conditions continue to worsen as net immigration to Europe and the rest of the world reaches levels not seen since the 19th century. The government aimed to reassure investors, but with an ounce of gold costing sterling-based investors over £10,000, it is difficult to see normal conditions returning to the UK anytime soon…

Or rather, is it just a queue of collectors keen to have one of the new Jane Austen £10 notes launched today?

My counterfactual history of events 10 years on from the financial crisis is clearly ludicrous. But whilst QE may be bad, it is like Churchill’s remarks on democracy: QE is the worst form of policy, except for all those other forms that have been tried from time to time.

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Nothing to fear except price itself?

Is the real challenge for fixed income markets solely their valuations? Most measures from the global real economy point to stronger PMI, lower unemployment or increased GDP – all suggesting that rates should be higher. So why are Treasuries at their lowest yields this year?

US rates are in the tug of war between bond bulls and bears, with bulls currently having the upper hand. There is little doubt that the 1% increase since the end of 2015 has done little to dampen the US economy; the counter to this is that the economy has not run away either, seemingly regardless of significant swings in the dollar’s value. Cheap debt has fed into all aspects of rates and credit markets as financial repression reduces yields across markets. Are we in a goldilocks scenario? Or should we fear more than price itself?

There are signs of individual sector stress that aren’t as noticeable at an asset class level. Carmakers, typically with higher credit quality, are selling fewer units, while online retailers are redefining valuations for second-tier shopping malls. Credit market quality is also a subject of debate. Looking back to 2005/06, many corporates have slunk to lower credit ratings. But for the most part debt serviceability is not materially impaired, and financials’ credit quality is demonstrably stronger.

Maybe North Korea offers the opportunity to shake things up? Spread widening reactions so far to missile tests have been measured in Richter scale numbers (single digits) rather than nuclear equivalent, tonnes (hundreds). This points to markets with lower volatility, but could be an implicit bull signal. Certainly if it is only a war of words and further sanctions achieve the removal of uncertainty, this could prove bullish for credit markets.

Of course central bankers are really key to whether we should expect more of the same or not. They have been hyper-proactive in support of monetary policy and balance sheets have grown dramatically. We are now headed into a period where a reverse is the case. The Phillips curve and other econometric models that tell us to expect inflation to materialise from current levels of unemployment and growth are being challenged. Central bankers are the pilots frantically tapping their instrument gauges, knowing they need to land but have to do it on their own as well as negotiate the crosswinds of investor sentiment.

Markets expect an orderly removal of stimulus over a long period of time – and that orderly process is captured in current market valuations. A disruption to this view could cause meaningful market volatility and a back-up in valuations.

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Back in the summer of… 2011

As fund managers interacting with our clients, the team often gets asked, “What’s the holding period for a trade”? And, given our strong belief in active management, we typically respond by explaining how we rotate our portfolios’ credit and rates exposure across issuer / sector / quality / currency to find the best value in the market. It’s not often we say “six years” and leave it as that.

But for those of you that have followed our strategic bond funds over the years, you will have noticed that we recently closed our long-held position in US Non-Agency Residential Mortgage Backed Securities (RMBS).

The aftermath of the great financial crisis created many opportunities for us as active managers. One of these transpired back in the summer of 2011, when we started to establish a position in US RMBS. These were bonds secured on pools of US mortgages that had been originated in the years 2006 and 2007 and were trading at very distressed prices (on average in the low 60 cents in the dollar). This reflected a US housing market still in a state of flux following the financial crisis, and an expectation that these bonds would experience losses as home owners defaulted on their mortgages.

At the time we believed that the pricing of the bonds reflected too pessimistic an outlook for the US housing market, pricing in significant further declines in average home prices. In our opinion, we were nearing the bottom of the housing cycle, and these bonds would perform well as the US housing market recovered. With the benefit of hindsight, we were six months too early in our entry point as US house prices didn’t trough until late 2011/early 2012. But as long-term investors and given the scale of the subsequent recovery, it is harsh to quibble about the exact timing.


Source: Bloomberg

We recently took the decision to exit this position. With average US prices now above the level they were before the financial crisis, we believe we have seen the bulk of the performance from the trade. That is not to say we believe there will be a downturn in US house prices, rather the bonds now more accurately reflect the outlook.

One of the skills we must have as active managers is the discipline to take profits on a successful trade. These bonds have been an excellent investment for our clients, with some positions generating an average return of close to 8% each year since our initial entry. They have also provided excellent diversification benefits for the funds, exhibiting very little correlation with other parts of the global fixed income market. In this case, it was well worth an extension to our typical holding period of a trade.

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Bank credit should be top of the list for income investors

The Global Financial Crisis (GFC) triggered fundamental changes to how the financial services sector operates. A slew of legislative frameworks ensued across most developed markets in an effort to prevent such a scenario from happening again. In the following years, the sector was subject to a plethora of new regulatory directives and frameworks on a global, regional and local scale. The common theme was ever higher capital requirements; the difference was how these would be met.

Fast-forward 10 years and most major global economies are in recovery mode (with varying degrees of activity picking up and unemployment falling). But the economic pain that followed the GFC is not forgotten – especially by the financial regulators. New and stricter rules require banks to hold ever more capital; it seems that each time the capital target is hit, the goal post is moved further away. From a credit investor point of view, this perpetuates a goldilocks scenario in bank credit: bank fundamentals are improving, but a large-scale redistribution of excess capital back to shareholders is constantly delayed due to the need to reach each new milestone, lowering the risk in bank credit.

As per the above, we are still in a regulatory convergence mode, and the end game is not yet in sight. What is certain is that banks’ fundamental profiles have strengthened significantly in the meantime. Most institutions now hold three times as much high quality capital compared to 2007, but this is not reflected in bond valuations. The spread on the junior-most capital layers of bank debt (the riskiest type) is five times more than senior unsecured bank credit (the safer layer), compared to just two times more in 2007. In terms of annual returns, the Bank of America Merrill Lynch Contingent Capital index achieved 5.8% in 2014, 6.9% in 2015, 7.3% in 2016 and 10.9% over 2017-to-date. The handsome yields on offer are also higher than bank equity, but with a lower volatility.*

As well as offering an attractive return profile, junior bank credit tends to have little discernible correlation to ‘traditional’ fixed income credits, as it is positively correlated to inflation and negatively correlated to interest rates. This offers investors significant diversification benefits using a building block fixed income approach.

Overall we believe that bank credit offers an excellent solution for those income investors that can look through short-term volatility and focus on annual total returns. As always, issuer and structure selection are key to avoid losses and capture the best income opportunities. At Kames we have a long history of successfully avoiding the losers in our high yield franchise, while our team combines over 30 years of fundamental bank analysis and research.

*Source: Bloomberg as at end July 2017, local currency returns. Bank of America Merrill Lynch Contingent Capital index ticker is COCO.Bank equity refers to EU Bank Equity Index’ dividend yield SX7P

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Prime time to checkout Amazon?

Amazon is a company that polarises opinion in the investment world. It has been variously described as the biggest not-for-profit organisation in the world to one that epitomises the new technology world we live in, a company that is at the vanguard of the equity-market-favoured “FAANG” quartet (comprising Facebook, Amazon, Apple, Netflix and Google).

Whilst there can be no disputing the incredible equity market performance it has exhibited this year (the equity is up more than 30% in 2017), it is fair to say that the credit rating agencies also have sharply differing views too – in their case on creditworthiness. It is not uncommon for Moody’s and Standard and Poor’s to perhaps differ by a notch or two in their assessment of an individual credit, but it is rare for them to diverge by four notches as they do in the case of Amazon. Moodys rate Amazon at Baa1, with Standard and Poors assigning one of its highest ratings for a corporation at AA- .

As part of its ongoing strategy to be a one-stop shop for all consumers, Amazon recently announced its intention to acquire Whole Foods Markets Inc, a takeover that would give the e-commerce giant more than 460 physical stores. This week saw the company issue a multi-tranche (7 dollar issues) deal to raise $16bln and help finance this acquisition. We viewed the 10 year tranche, initially to be priced at 110bps over the underlying US Treasury, as good value relative to the secondary market curve. However, spill over from equity market enthusiasm ensured the deal finally priced at spread of 90 over for Treasuries. A stretch too far for us; the deal left investors with little value and Amazon with a very competitive cost of funds.

The Amazon example is very representative of our investment style; we try not to be too dogmatic in our assessment of individual credits; we look to buy good investments, which is not always the same thing as buying a good company. We will leave “not for profit” investing to the experts – like Amazon.

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Masterly manipulation

“Masterly manipulation” it was called by J.M.Keynes in secret papers in the 1920’s. Today we call it QE. 

A fascinating and only recently discovered entry in old Bank of England ledgers revealed that in 1914 the Bank was forced to purchase Gilts for itself as there was insufficient demand for its new issue. The issue of the £350m “War Loan” in 1914 was reported as being a success; press articles of 1914 talk of demand ”pouring in” for the deal. Yet, £250m of the transaction was never sold and quietly shuffled away on to the Bank of England’s ledger – or balance sheet.

So what have we learnt from this historical discovery?

1) Just because the newspapers (social media, today) say it’s a good deal it doesn’t mean it is a good deal. Having some healthy scepticism is “stock-in-trade” for the Kames Fixed Income team, and we trust for our readers.

2) QE will happen in extremis but ultimately it is about delivering confidence. In 1914 it was about financing a European war and failure to be seen to be doing so would have had huge political ramifications. Similarly, in 2009 confidence in the financial system was shot and QE helped rebuild confidence in the system. Something had to be “done” and globally central bankers responded by tripling their balance sheets over the next eight years.

3) It has taken over 100 years for the “masterly manipulation” of War Loans to come to light. Despite some disquiet, Gilt purchases in the UK or purchases by other central banks have been done in an open, transparent and formulaic fashion. With today’s QE there is no obfuscation with the purchase process but QE’s unwind is less clear and a matter for public debate. Institutional transparency is a part of the confidence we have in our system. We may not like QE but it’s a whole lot more transparent than a hundred years ago.

(Thank you to the authors of the excellent bankunderground blog: https://bankunderground.co.uk/2017/08/08/your-country-needs-funds-the-extraordinary-story-of-britains-early-efforts-to-finance-the-first-world-war/#more-3230)

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Reports of my death have been greatly exaggerated – the Sterling corporate bond market continues to thrive

More than a year has passed since the Bank of England announced its £10bn Corporate Bond Purchase Scheme (CPBS). While the scheme was completed by April, much more quickly than originally anticipated, its positive impact on the market has been lasting.

Prior to the Bank’s intervention the importance of the sterling corporate bond market was under threat, in part due to poor secondary liquidity and a lack of supply from borrowers drawn to the depth, convenience and competitive pricing of the euro and dollar markets. Even UK-centric borrowers such as Royal Mail favoured the euro market over their home turf.

The backstop bid that the Bank’s scheme provided gave market makers the confidence to increase secondary liquidity through tighter bid/offer and larger size. There was concern as the scheme drew to a close in April that the improved liquidity would diminish but this hasn’t happened. Higher volumes have persisted and market participants are more confident trading larger blocks. A marked increase and greater variety of new issuance over the course of this year (gross issuance year to date has already surpassed full year 2016 volumes) has also helped to define market levels and encourage further secondary activity.

To this end, the Bank’s intervention has been a great success. A more dynamic market presents further opportunities for us as active managers to express views and add value to portfolios for the benefit of our clients.

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Does the unreliable boyfriend ever want to be Action Man?

The Governor of the Bank of England (BoE) has just said, as it released its Quarterly Inflation Report, that it expects to reduce stimulus more than the market is currently pricing.

Yet the bond market rallies.

The BoE reduced growth and wage expectations for next year, while still predicting above-target inflation three years out, and keeping alive the prospect for a rate hike. One way to square that circle is if it has lowered its assumptions about the potential growth of the economy – meaning that even if we beat trend growth just a little bit, we will be reducing slack in the economy, enough to warrant a reduction in stimulus. In other words, the UK has an even lower bar to beat. This could be seen to be hawkish.

Yet the first reaction of the market was one of scepticism, pushing out rate hike expectations even further. The Monetary Policy Committee (MPC) may now face a communication problem. It has to convince the market that it is serious about raising interest rates, after the hawkish noises heard earlier in the summer were not followed through in today’s vote (as per our earlier article, http://bondtalk.co.uk/macro/monetary-policy-soft-or-hard-approach-not-just-a-political-dilemma/ Haldane could have made it 5-3, yet the vote was 6-2).

Perhaps the best way for the MPC to communicate that it wants the market to price higher interest rates is to actually deliver and reduce the stimulus put in place last August – that will certainly get the market’s attention.

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Valuations Sour the Green Apple

This week saw the issuance of Apple’s second green bond, a $1billion 10-year transaction to help fund its goal of running 100% of the company’s operations on renewable energy. The issue builds on $1.5billion of green bonds sold by Apple a year ago, the biggest ever green bond issued by a US corporation. Whilst Apple has plenty of cash on its balance sheet the company’s issuance has helped fuel a surge in dollar green bond issuance last year, with 2016’s supply doubling 2015’s total issuance. This year so far, around $120billion worth of green bonds have been issued by corporations.

Apple has an agenda, epitomised by CEO Tim Cook attempting to persuade Donald Trump not to leave the Paris Climate Accord. Apple is committed to making the future iPhone solely from recycled materials but currently only a small percentage of the current iPhone is made from them. Apple has identified a number of materials used in their products which can be recycled and used in new products, for example aluminium that is used in the current iPhone 6 can be melted down and used in Mac computer cases.

December 2016 also saw Apple investing in four subsidiaries of China’s largest wind turbine manufacturer, Goldwind, taking 30% stakes. They are targeting directing power from the wind turbines to Apple manufacturers based in China. The company is currently using renewable energy in 96% of their stores and factories with the goal of increasing this to 100%. Apple scores very well in the E component of our ESG scoring but controversies still lie around their supply chain management, use of child labour and hazardous chemicals usage.

For investors the new green bond was fully priced at +82bps spread over the US Treasuries curve. Initial price talk at +95-100bps would have offered investors some value at launch but final pricing left little to excite. In the basket of Apple bonds this wasn’t necessarily the one to pick and, whilst the ‘green’ label is to be applauded, for a company the size of Apple corporate responsibility is more material than the odd billion of green bonds.

UK election positives

It is early days yet but it looks like Theresa May is going to be returned as prime minister as the Conservatives form a government with support from the Democratic Unionist Party (DUP). On first glance it seems a bit of a mess but taking a closer look at the results there are some positives.

Firstly, the share of the vote taken by the mainstream parties has risen as a proportion of the vote. Or putting it another way, the share of the vote taken by the extremes has fallen. The country as a whole has moved towards the middle. In England, from Right to Left, in Scotland from independence (as supported by the SNP) towards unionist, and in some places, from Anti-EU (Tory) to EU (Liberal Democrats).
What does this mean for policy? Perhaps the same – moving towards the centre, compromising on the issues that the UK faces, which could be a positive outcome.

So for example, the probability of a second independence referendum in Scotland has been reduced.  Many SNP seats were lost on this issue. Scotland is not usually prone to voting Conservative but in this election they represented the strongest voice against Independence.

Negotiations with the EU will have to be less extreme, particularly as the DUP does not want a ‘hard border’ with the Republic of Ireland. You could make the argument that a cross-party team could be appointed to lead negotiations in the national interest, but maybe that is too farfetched. However, with the decline of UKIP, it doesn’t seem likely that the current position can move any further anti-EU.

With regard to tax and fiscal policy, we can probably expect some movement towards the left, i.e. higher taxes and higher public expenditure; the Conservatives lost badly on this issue to Labour. We can probably expect the pledges regarding minimum wages being fulfilled and some of the cuts that were floated (e.g. school lunches) being abandoned.

What does this mean for UK fixed income? Probably very little, with easier fiscal policy being outweighed by reduced extremist political risk. And sterling? It could be positive depending on the Brexit negotiating stance. Monetary policy is likely to stay stable thus supporting fixed income, sterling has depreciated a lot versus both euro and US dollar over the last year, so this political event – as messy as it is – in my view is unlikely to push sterling to new lows.

Europe not Spain executes Popular wind-up

Banco Popular’s equity and subordinated bondholders have been wiped out today. To come to this end, the EU’s Single Resolution Board (SRB) has exercised its power to resolve the Spanish bank after the ECB stating last night that the lender is ‘failing or likely to fail’. The exact mechanics follow a €9.1bn provisioning and capital shortfall being identified which necessitated the writing down of equity and AT1, as well as conversion of T2 debt into Shares of Banco Popular while simultaneously transferring that equity to Banco Santander for a total consideration of €1.

Some market participants have surely been taken aback this morning by the abrupt and radical way of dealing with a failing financial institution. After all, this is the first time when the relevant resolution authorities apply the widely-advertised Bank Recovery and Resolution Directive (BRRD) rules so in essence this is the first real-world test of the new playbook. As a reminder the BRRD was put in place a little over three years ago with an explicit target to limit market and public sector implications that have in the past ensued from a failing systemic financial institution.

In that respect, albeit relatively early to say, we can observe that the first attempt of breaking (or at least loosening) the bank-sovereign nexus seems to have been a moderate success. At the time of writing, the yield on the 10-year Spanish government bonds has hardly reacted to the event. In addition, not only are there no early signs of a broader market fall-out, both within the AT1 subset as well as across peripheral banks, but the broader market tone is actually constructive, with peripheral bank AT1s leading the gains.

The muted to positive market reaction to what many feared would be a catastrophe for a nascent asset class only one year ago illustrates several key facts; 1) investors are now much better educated on the risks and mechanics of the AT1 instrument 2) the regulators have come some way to address broader market concern regarding risks in these securities and 3) the strict application of the new resolution tools gives confidence that these are not just on paper but will actually be applied as intended in a uniform way.

That last point is very important in my view in restoring the ability to price risk in future similar instances and should reduce risk premia across the capital structure going forward. We still have fresh memories of widely diverging approaches in what looked like similar instances in the past (SNS Reaal, ING/ABN/KBC bailouts, Monte Paschi). It may well be too soon to say that these examples are surely a thing of the past, but for the time being the market seems to be taking exactly that view.

Taxi Driver – the sequel

Sequels are rarely good as the first. In Robert De Niro’s original 1976 film, Taxi Driver, Vietnam veteran Travis descends into New York’s low life as sexual infatuation and delusion overtake him.

As the original is based on sex it’s no surprise that the sequel is about money. In this case the cost of being allowed to buy a New York cab licence, known as a “medallion”, and its implications.

New York cabs is a regulated market with around 13,500 medallions allowed. As New York recovered from the 2008 financial crisis, the cost or value of a medallion increased dramatically to $1.3m in 2013 being driven by a combination of this restricted market and cheap money.

And today? Medallions sell for $241,000 as Uber decimates the existing regulated taxi business. This is not without implications. Clearly the disruption caused by technology – Uber in this case – has destroyed the value of the incumbent market by 80%. No wonder taxi drivers are angry.

The figures from Capital One – the US lender – show why it’s a problem. Most cabbies don’t have the cash to buy a medallion, so borrow it. Capital One has $655m of loans to cabbies and the non-performing loan rate of that part of its lending is 52.7% – doubling over the last year. For Capital One it is a huge hit in a tiny part (0.25%) of its overall lending. Evidently chastened by large write-offs in small areas, Capital One tells us it is “building a tech brand”: reading through Capital One’s annual stockholders’ presentation and its key (basically only) theme is “disruption caused by technology”.

Lenders are starting to understand this to ensure they can effectively manage exposures to sectors under stress (e.g. cabbies) to ensure their profitability. The lesson here is that the negative effects of disruption emerge in unexpected places.

Taxi Driver the sequel has a less happy ending than the original. De Niro runs out of bullets to shoot himself but I suspect the sequel sees the cabbie succumbing to his debts. For Hollywood, the villains will clearly be bankers, but the real – and unseen – villain is surely technology.

UK election; early thoughts

It seems a done deal that the Conservative Party will win the 2017 General Election and will increase its majority in the House of Commons. The Conservatives are around 17 points ahead in the opinion polls and the Labour Party’s election campaign to date can best be described as unfortunate. Senior party members appearing to have little knowledge of basic arithmetic and the leakage of the manifesto before the official launch haven’t helped.

The gilt market and sterling are heading into this political event with a reasonable sense of calm; unusual in the context of the last three years of potentially destabilising political events, starting back with the Scottish Referendum in 2014. The expectation appears to be that an increased majority in the House of Commons gives Theresa May the negotiating power to negotiate a ‘better’ Brexit. Many have interpreted this as ‘softer’ i.e. closer to the EEA (European Economic Area) or EFTA (European Free Trade Area)-type arrangements, rather than the imposition of hard borders and resorting to WTO rules regarding trade. This has led to sterling strength against the euro and the US dollar in recent weeks.

Unfortunately it is not clear what her Brexit negotiating stance is yet. On closer inspection of the opinion polls, we see that it is the UKIP support that has collapsed and switched to the Conservative Party. The Conservative manifesto has not been published (or leaked) yet so we are still to see if the currency and bond markets have made the right assessment of a ‘better’ Brexit. What we do know is that Theresa May is firmly rejecting the idea of Free Movement of Workers, with her commitment to reduce immigration to less than 100,000 per annum. This concept is completely at odds with the pillars of free trade in the EU, EEA and EFTA.

Sterling has appreciated over 2% on a trade-weighted basis over the year to date. Gilt yields have fallen from 1.5% at the 10-year maturity to closer to 1.0% as concern over imported inflation abates.   It seems to me that although the outcome of the election is of little dispute, the outlook for Brexit and the UK remains uncertain, and the risks rise again on 8 June.

Starting the Final Lap

The final lap of the race for the French presidency has started. Emmanuel Macron with 23.75% of the votes and Marine Le Pen reaching 21.53% will compete for the second round of the French presidency on May 7. Voter turnout was 78.69% versus 80.42% in 2012.

French sovereign and corporate bond markets rallied on the back of the first round results and investor political focus will now move to the UK in June and Germany in September.

For the first time under the Fifth French Republic, neither of the two traditionalist parties (Socialists and Republicans) will be present in the second round. The magnitude of this political earthquake is amplified by summing all the extreme votes together, leaving an elevated dispersion in the French political landscape.

After the preliminary results, most of the political figures called to vote for Emmanuel Macron and to form a republican front to preclude extreme ideas reaching the Élysée Palace. Jean-Luc Mélenchon kept his distance and refused to call to vote for any of the candidates.

Emmanuel Macron is the clear favourite for the second round. The polls place him above 60% with a low uncertainty component for his voters (only 8% are not sure of their choice versus 15% for Marine Le Pen). However, his score should be lower than Jacques Chirac in 2002, the last time that the extreme right party reached the final round of the French election.

It is important to note that the polls were extremely accurate, with less than 1% difference for each candidate and the correct order. This is a strong positive for the second round as given the level of accuracy it is hard to imagine Emmanuel Macron losing 20 points to Marine Le Pen.

After the second round, the legislative election will be paramount as the country could end up tough to rule without a majority in parliament. This is the biggest weakness of Emmanuel Macron which could lead to an incapacity to reform the country with every initiative blocked by the opposition.

Official results: French election first round

The coupon’s round trip

A few days ago we wrote about the possibility of the US Federal Reserve not reinvesting maturing bonds in its QE programme. Over time this would see the Fed’s portfolio of bonds reduce to zero (a very long time). This debate is about the reinvestment of maturities, but of course ignores those tricky little coupon things.

There are a whole load of technicalities around the administration of this, but it is in governments’ interests that the QE unwind happens slowly.

Why?

Let’s look at the UK. With the Bank of England (BoE) owning £435bn of gilts, Her Majesty’s Treasury (HMT) pays £15bn to the BoE.

If the BoE kept those coupons, the amount of bonds would compound by about £15bn a year, which, over time, would exponentially increase the nominal amount of bonds held by the BoE. This would lead to the BoE in essence being dominated by that relationship – which is not ideal for a central bank tasked with delivering independent advice.

Thus, the £15bn of coupons are sent back to HMT; a “round trip” that in essence means HMT has more money in its pot – and all of the political implications around that large dollop of money.

It is odd that this receives such little attention. It should be a charged and political issue given its enormity, but it gets lost in the vastness of QE.

Kondratieff

On Tuesday we hosted a conference where we heard from our own team and a couple of economists. Chris Watling at Longview Economics takes a, well, long view. He is quite a proponent of Kondratieff. Who he? Starting at the end, he faced Stalin’s firing squad in 1938 at the age of 46. Prior to that he had held office in 1917 as deputy minister for supply before the second, October revolution of 1917 after which he moved to academia but ultimately falling foul of Stalin’s fanaticism and being sent to the gulag.

However, in 1922 he published his first book on the long cycle. A simplified explanation is that as capital is invested it creates monies which are reinvested in similar products that are produced more cheaply until this process leads to a loss of confidence and people hoard cash rather than invest. The long cycle is around every 35 years and the slide below suggests we are at a turning point, having seen new lows in government bond markets in 2016.

I don’t dislike this explanation of the world but it has its limitations as well as practical investment limitations. Bond yields may well be materially higher in the long term but as managers we are judged on monthly, quarterly and annual performance. As yesterday’s 10bps rally in 10 year US Treasuries AFTER the Fed rate hike proves, there are plenty of opportunities on the journey to slightly higher yields.

US 10 year bond yields – 1900 to present (showing Kondratieff cycles):