Fund managers see silver lining to the end of cheap credit

The end of cheap credit will cause shifts in investor behaviour, undoing some of the habits learnt over a decade of central bank largesse. But many investors are holding steady, betting on higher economic growth compensating for any short-term tantrums in asset markets.

Last week bullish comments from central bankers on the ending of monetary easing caused a bond sell-off. When interest rates are rising, fixed income products like government bonds become relatively less attractive to investors, forcing prices in secondary markets to fall (and hence returns, or yields, to rise) in order for investors to be willing to buy those bonds.

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Are we set to see the next ‘taper tantrum’?

In a week where traders will focus on Janet Yellen’s congressional testimony and core CPI, there are signs we could be set to see bond markets drive higher financial market volatility and equity weakness. (This video was produced in commercial partnership between Fairfax Media and IG Markets).

The “taper tantrum” also impacted Wall Street, where shares, also inflated through loose monetary policy, were initially sold off before recovering on Friday following some strong jobs numbers. 

Over the past month, the yield on 10-year German bonds has more than doubled, from a low of 0.23 per cent on June 15 to 0.57 per cent by the close of trading on Friday.

US 10-year yields have gone from a low of 2.1 per cent on June 14 to 2.4 per cent on Friday. Even though Australia’s central bank shows no signs of following others in raising rates, Australian 10-year bonds have also been sold down, with yields going from 2.3 per cent on June 15 to 2.7 per cent on Friday.

For years, easy credit has pushed investors towards riskier investments for returns, UBS’ head of investment strategy, Tracey McNaughton, in Sydney argued in March.

“When central banks stepped in and flooded the market with liquidity, it not only changed prices in the market, it also changed behaviour. Fundamental drivers were pushed aside. Correlation [of yields across all asset classes] rose, as did herding behaviour, and the overcrowding of positions made markets vulnerable to tantrums,” she told Fairfax Media at the time.

Ths situation is now reversing, with central banks in Europe signalling an end to asset purchases, while the Fed is expected to raise rates one more time this year to bring the number of rate hikes in 2017 to three.

Market impact

How markets will position themselves for this anticipated shift is one of the key questions facing investors.

On the ASX, bond proxies may be the first to suffer, according to Credit Suisse’s Hasan Tevfik. In a July 5 note to clients, he warned that the ASX was unusually dominated by sectors such as energy, infrastructure and listed property trusts, which make up 22 per cent of the ASX200. These sectors can mimic the fixed-income market in their steady returns but become less attractive when bonds offer higher yields.

But not everyone expects this to be a long-term stress on the sector. Atlas Fund Management has a heavy exposure to such companies, having recently listed a property-focussed fund on the ASX.

Its chief investment officer, Hugh Dive, took a sanguine view of the risks of higher bond yields on his investments. He said bond selloffs have a two-stage impact on equity market performance.

“In the initial stages … bond proxy sectors such as utilities, infrastructure and listed property trusts are sold off. This is due to the compressing of the yield differential they enjoy and the risk-free [bond] rate.

“In the medium term, higher interest rates generally signal global growth and higher inflation. Greater demand allows higher prices.”

For example, higher economic growth would provide a boost to Transurban through usage of its cross-city tunnels, allowing it to increase tolls. Meanwhile, listed property trusts enjoy greater demand for their properties as the economy improves, allowing them to increase rents.

Vacant space, Mr Dive noted, is the greatest risk to the profits of listed property trusts, which generally give investors yields of about 5.1 per cent per annum.

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