There is nothing more wearisome than a panel of experts at a conference who all agree with one another. Fortunately for the audience, a panel of fixed-income experts yesterday at a conference on global bond markets held in Hong Kong failed to see eye to eye.
Scott Peng, director at Citigroup Global Markets and head of US interest rate strategy, outlined a bleak view of the bond markets in 2006, arguing that trends were headed for stagnation, meaning active managers would struggle more than ever to add alpha.
Three panellists from the fund management world disagreed and said in fact opportunities continued to exist, but these would require more flexible mandates from clients.
Peng, noting that in 2005 global sovereign and aggregate bond indices have returned the worst performance in five years, believes that 2006 looks even worse. Narrow spreads, low volatility and flat yield curves are likely to continue.
He realizes that as we near the end of the US Federal Reserve's pattern of gradually raising short-term interest rates, there will be a bull market in bonds. But Peng says managers cannot expect to generate the same bang for the buck anymore. When the Fed stopped a cycle of tightening in 1994, the bond market saw a 400bp rally. A similar event in 1999 led to a rise of only 300bp, and Peng predicts 2006's expected rally will generate only 150bp - and that is his most favourable scenario, assuming that 10-year Treasury bond yields would fall to 3% as bond prices rose, which seems unlikely.
In other words, a similar measure of risk will not generate the same degree of alpha as in the past, despite the conclusion of the current trend in interest rates.
Other trends are also petering out but are unlikely to provide a boost to investor returns, Peng says. This includes the flattening of yield curves, which instead of becoming steep again, will probably just remain flat for much of next year. He says yield curves do not move to a steeper position until six to 12 months after the Fed stops tightening, as the market needs time to become convinced that interest rates will not rise again. Since the market consensus is that the Fed's tightening cycle will continue into early next year, the yield curve will remain prostrate through most of 2006.
It is a similar story with spreads, which have hit near-historical lows. Companies will have to begin to leverage their balance sheets to replace slowing organic growth, but this will not translate into wider spreads for a period of time.
Finally, option-implied volatility (which measures the price the market pays to hedge uncertainty) looks likely to remain low. The traditional buyers of options, such as America's mortgage agencies, have slowed their activity, while many players such as hedge funds are trying to sell volatility as vol levels continue to drop. So Peng argues that while volatility will make a return in 2006, it will not be as much as many fund managers hope.
But fund managers on the panel argued that there are more opportunities than Peng's analysis recognizes. "When people expect nothing to happen, something does," says Matthieu Louanges, senior vice president at Pimco Europe. "In 2005, everyone remained invested in short-duration securities because they predicted yields would stay low." But the past two months have witnessed a surprise sell off. Louanges believes yield curves can move.
Next year he believes the US government will move from fiscal stimuli to fiscal retrenchment, while the Fed will encourage less consumption by Americans in order to address global imbalances. Companies on the other hand are in good shape and will begin to invest more. Next year is not the time to be short US bonds, he believes.
The difference to past rallies, Louanges says, is that in the past, fund managers relied on directional bets and credit to find alpha. Those routes do not look promising now so managers are moving into uncorrelated niches and using derivatives.
Cecilia Chan, director and head of fixed income at HSBC Halbis Partners in Hong Kong, says that 2006 should prove more interesting than 2005, not duller. She notes that economists have shared the same expectation for 2005, that the Fed would gradually tighten policy. But there is no consensus on what happens next year, and portfolio managers will find ways to add value, particularly through duration management.
Andrew Wells, CIO for Asian fixed income at Fidelity Investments in Hong Kong, also disagreed with Peng's view, and noted that the past several months have seen incredibly good bond performance and high information ratios. "The surprising thing is how resourceful people can be in finding new areas to make alpha," he says.
Despite these apparent conflicts of opinion, Citigroup's Peng says that the managers' arguments do not really diminish his arguments. He believes the trend toward narrowing opportunities in bond market rallies leaves rather little on the table for the same amount of risk.
And he says that it only takes, say, two of his four themes (interest rates, yield curves, spreads and volatility) to conk out in order to hinder managers' ability to make returns. "If just two trends stagnate, you've taken away a lot of fund managers' alpha-generation firepower," he argues.
Moreover, the bond fund managers' belief that they can add value for clients rests on the assumption that they will be given a free hand to make many types of uncorrelated bets across asset classes, and using the tools at their disposal.
Cecilia Chan at HSBC notes that the biggest challenge in this environment is getting clients to give their external managers reasonable guidelines and relaxed restrictions. Many Asian institutions have been slow to provide this leeway, often because they misunderstand the true nature of their risks, and thus they face an opportunity cost.
Fidelity's Wells adds that managing client expectations is a tough job, and asks investors to be realistic about what can be achieved in the current environment. He notes that lobbying regulators to allow managers to use tools such as credit-default swaps does work, however.
One area of opportunity that Peng says will help fund managers out-perform next year will be Asian fixed income. But the fund managers note there is much to be done in this area to allow it to play a bigger role. This includes encouraging Asian companies to issue bonds instead of rely on cheap bank finance, to issue in currencies other than the dollar and to develop swap curves; and getting governments to deepen markets, issue inflation-linked securities and in some jurisdictions scrap withholding taxes.
Peng may believe that the outlook for making returns in the bond markets next year are poor, but he is careful to note this is temporary. Over the next five to 10 years, he sees trends that will make global bond markets very attractive. Formerly captive investment pools may be unleashed, leading to new sources of liquidity, if certain reforms are realized. These potentially include $1-2 trillion from Japan's privatizing post office; another annual $2-300 billion derived from the reform of America's Social Security system and its defined-benefit programmes; and up to $600 billion annually as America's baby boomers gradually shift more into bonds.