Bond Rout Sparks Inflection Anxiety

Worst credit market sell-off since 2010 suggests long bull market may be ending.

Bonds of all types worldwide are generating their biggest losses since 2010 this month, raising concern that the four-year bull market that pushed interest rates to record lows may be ending as the flood of easy money from the U.S. Federal Reserve subsides.

“For a very long time, the market dynamics in interest rates have been overwhelmed by Fed monetary policy,” said Jeffrey Rosenberg, chief investment strategist for fixed-income at New York-based BlackRock Inc., the world’s biggest money manager, which oversees $3.5 trillion. “Has the big inflection point been reached?”

From the debt of U.S. government and Latin American phone companies, from Japanese prefectures to Shariah-compliant borrowers, fixed-income securities have lost 0.65 percent on average in March, their worst performance since tumbling 1.09 percent in November 2010, according to the Bank of America Global Broad Market Index that tracks about $40 trillion of bonds. The drop has been led by U.S. Treasuries, which are down 1.5 percent, including a 5.9 percent plunge in the benchmark 30-year bond.

Global debt markets have trounced stocks since mid-2007, returning 29 percent versus a 4.44 percent loss after dividends for the MSCI ACWI index, as the Fed led central banks in cutting benchmark interest rates to record lows and provided extraordinary cash to pull the global economy out of the worst financial crisis since the Great Depression.

Now, with signs the recovery in the U.S. economy -- the world’s largest -- may be self-sustaining, money markets show traders expect the Fed may raise borrowing costs a year sooner than its target of late 2014. In Europe, futures show expectations of further easing by the European Central Bank have been priced out of the market.

“Global bond markets have enjoyed a three decade long bull rally,” UBS AG currency strategists led by Mansoor Mohi-Uddin in Singapore said in a report to clients on March 16. “But this era is now set to end.”

The firm noted that it’s unlikely that the Fed conducts a third round of bond purchases as the U.S. recovery gathers pace, private sector credit expands, China and other emerging economies rebound in the second half of 2012 and the euro zone’s recession fails to shock the global economy.


Next Step

While Credit Suisse Group AG agrees that the global economy is firming, it says another round of quantitative easing by the Fed is still on the table.

“We still believe that the next Fed move will ultimately be toward the more accommodative policy, although the timing will depend on the contemporaneous data,” the firm’s economists led by Neal Soss in New York said in a March 16 research report.

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. declined for a ninth day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 1.2 basis points to a mid-price of 87.4 basis points as of 10:56 a.m. in New York, according to Markit Group Ltd. That’s the lowest level on an intra-day basis since May 2.

The index typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.64 basis point to 24.74 basis points as of 11:02 a.m. in New York. The gauge, which reached a six-month low of 24.69 on March 2, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

Bonds of Charlotte, North Carolina-based Bank of America Corp. are the most actively traded U.S. corporate securities by dealers today, with 46 trades of $1 million or more as of 11:02 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Average yields on bonds worldwide have climbed to 2.166 percent after reaching a record low 2 percent on March 6, according to the Bank of America Merrill Lynch Global Broad Market Index. That’s down from almost 5 percent in mid-2007.

This month’s losses in the global bond market have trimmed gains for the year to 0.64 percent, including reinvested interest, according to the Bank of America Merrill Lynch index. The last full year that the index declined was 1999, falling 0.26 percent.

Investors are questioning how much momentum is left in the bond market rally after the Federal Open Market Committee improved its outlook for growth on March 13, reducing speculation the central bank will begin a third round of asset purchases known as quantitative easing, or QE3. The central bank bought $2.3 trillion of securities in two rounds of bond buying from December 2008 to June 2011.


Fed Rate

At the same time, the FOMC reiterated in a post-meeting statement that the joblessness rate is “elevated” and “significant downside risks” remain.

Unemployment persists at 8.3 percent, even after the most robust six-month period of job growth since 2006, and Bernanke is holding to his plan to keep the Fed’s benchmark interest rate low through at least late 2014. The target federal funds rate has stayed at zero to 0.25 percent since December 2008.

Forward markets for overnight index swaps, showing what traders expect the federal funds effective rate to average over the life of the contract, signal a quarter-percentage point increase in approximately September or October 2013, data compiled by Bloomberg show. Last month, no increase in the effective rate was predicted until early 2014.

“It’s apparently started,” Leon Cooperman, the chairman, chief executive officer and founder of hedge fund Omega Advisors Inc. in New York and a long-time bond bear, said in reference to an anticipated rejection of debt securities. “It could be a false start,” he said in a telephone interview last week.

Yields are leaving some investors questioning the rationale for buying securities that pay less interest than the inflation rate. Treasuries are “the most overpriced investment in the world,” Omega’s Cooperman said.

Jeremy Grantham, chief investment strategist of Boston-based Grantham, Mayo, Van Otterloo & Co., called avoiding long-term debt the “one great opportunity” in asset allocation in a letter to investors last month.

Not all investors are convinced the Fed will change course on rates, according to Laird Landmann, a portfolio manager at TCW Group Inc., which oversees $70 billion in fixed income.

“This could be the beginning of a turning point but it definitely won’t be a one-way trip to higher rates,” Landmann said. “Any bad news out of Europe, any slowdown in what have been very positive economic signals over the last three months, could cause this market to rally back.”


Bloomberg News


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