Bond buyer beware in choppy markets

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The last three months have seen some dramatic movements in the markets.  Following Ben Bernanke’s comments in June that the Fed would be reviewing its quantitative easing (QE) program with the view of easing the US$85 billion per month bond buying program, global markets sold off dramatically as investors switched out of ‘risk assets’.

Further to this, the Federal Open Market Committee (FOMC) minutes showed members were described as being “broadly comfortable” with Bernanke’s plan to start reducing bond buying later this year, if the economy improves. The latest public comments however, which came after the July FOMC meeting, have shown an increasing willingness to commence the taper as soon as September.

Taper me this

In response, large movements were seen in equity, currency and bond markets, the latter impacted by the realisation that a very larger buyer of bonds will no longer be there when QE is removed, therefore reducing demand. The market reaction was a fall in government bond prices and an increase in yields (given the inverse relationship between fixed rate government bonds and yields).

The following graphs show the movement in 5-year AUD swaps and the iTraxx Credit Default Swap (CDS) index (which is an indicator of credit risk – the lower the spread, the lower the perception of credit risk).

We can see both measures have increased over this period, most notably the spike in late June when Bernanke first made his comments. In regard to the Itraxx, since index lows in May, spreads have widened some 30 basis points, primarily as expectations firmed regarding the Fed’s scale back of monetary stimulus.

Swap curve steepening

If we look at the change in the 5-year swaps curve from 12 months ago compared to today, we can see the dramatic effects of recent market movements.
The pale blue line shows the curve 12 months ago. At that time it represented a shallow ‘U’ shape, indicating that there was value on offer in the short-dated market, which for most investors is the term deposit market. In fact, the curve was offering better returns for 30 days than it was for 3 years. The curve has now flattened in the short end and steepened at the long end. This suggests there is now better value on offer further out along the curve.

So where to invest?

The widening of credit spreads combined with the steepening in the yield curve presents opportunities for investors. While widening credit spreads lead to better yield for investors at all maturities, the steepening adds additional return at long end of the curve. So for investors holding fixed income securities, the message is to consider moving out of shorter dated securities and move into longer dated maturities. Or look to take advantage of the volatility and buy on the wider spreads.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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