Trillion-dollar monster lurks as bonds price out duration risk
Investors riding easy-money policies are breeding a trillion-dollar monster in the bond market, the likes of which has never been seen in decades of history.
Wall Street will tell you it is low-risk for now — one that’s been hyped-up for years. But on the current trajectory, just a modest bump in yields near record lows could inflict a world of pain for traders all over the globe.
Dovish monetary bets, relentless demand for safe assets and conviction in the lowflation era are spurring money managers to gorge on long-maturity bonds, or duration risk.
One measure of the relative compensation investors receive to hold longer-dated obligations is a whisker away from a 58-year low. In Europe, they’re taking a century of risk for yields barely above 1% in order to escape a $13 trillion global stockpile of negative debt.
All that is leaving duration, a measure of sensitivity to interest-rate changes, near all-time highs across sovereign debt markets. As hopes rise of a U.S.-China breakthrough on trade, bond bulls could suddenly find themselves on the backfoot.
For Thomas Graff, it may be too late to board this bull train.
“Buying duration isn’t a great trade anymore,” said the head of fixed-income at Brown Advisory. The firm has been curbing exposures to longer-dated risk since big bets are already priced into markets, including U.S. rate cuts. “Even if we are heading toward a place of lower rates — or even if the current range is a kind of normal — it’s not going to be a one-way train.”
While “speculative” long-duration wagers are a risky proposition, using fixed income makes sense for funds hedging risk assets, Graff said.
As Austria bags more than $5.7 billion for a new century bond Wednesday, the likes of Pimco, Amundi and Lombard Odier Investment Managers don’t see longer-term premiums awakening from their slumber anytime soon.
JPMorgan Chase estimates U.S. mutual funds with active mandates have recently increased long-duration exposures after turning underweight last month.
One gauge of the compensation investors demand to hold longer-term Treasurys versus rolling over short-dated obligations, known as the term premium, is near record lows — underscoring the intense conviction in the low-rate, lowflation era in markets. Over in Europe, the ask yield on Swiss bonds due 2064 even fell below 0% last week.
It’s easy to see why bulls have taken control across the developed world.
For years, bearish prognostications have proved off the mark, with everything from global savings and aging populations to monetary shifts depressing yields. Now, geopolitical risk, central banks in dovish mode and the aging business cycle are reinforcing the bullish moorings in global debt.
But just look at the math. The Macaulay duration on a Bloomberg Barclays sovereign-debt index is near a record high of 8.32 years, meaning just a one-percentage-point increase in yields would equate to more than a $2.4 trillion loss.
Nasty surprises could be in store for those who think they’re boarding a one-way train. The U.S. is willing to suspend the next round of tariffs on an additional $300 billion of Chinese imports while Beijing and Washington prepare to resume negotiations, people familiar with the plans said. In a recent interview, Treasury Secretary Steven Mnuchin sounded an optimistic note that a deal could be reached.
The prospect of easing tensions in global commerce is one thing keeping Pimco from duration overweights, despite the firm’s conviction that the Fed is at the peak of its hiking cycle.
"We are broadly neutral in the near term as there’s still a lot of uncertainty," said Nicola Mai, a portfolio manager at Pimco in London. "The Fed might stay on hold if there is positive development."
Trade deal or not, Lombard Odier sees any rise in yields as a buying opportunity.
“Rates sell-offs are a bigger risk when we get tightening,” said Salman Ahmed, the firm’s chief global strategist. “In the next few months, we are likely to see almost every central bank easing.”
Over at Amundi Asset Management London, extended duration in the market isn’t keeping Laurent Crosnier awake at night. But he’s pondering a longer-term tail risk: central-bank impotence in boosting growth could even spark a sell off one day.
“At one point the market may start challenging central banks about the effectiveness of their monetary policy,” said the chief investment officer. “They may start pricing in credit risk, and that’s going to push yields higher.”