November 18, 2012 9:01 pm
Bond markets: A false sense of security
Investors seek perceived refuge in bonds but fears are rising that their faith has been ill-placed
New york, shadows of pedestrians passing by a steam pipe,on wall street©Corbis

The demons afflicting market sentiment could be described as the “three FCs”. Tormented by the financial crisis, flash crashes and the impending fiscal cliff, investors have turned to the time-honoured refuge of bonds.

But savers who have stocked up on bonds with record low yields face danger on two fronts: on the one hand, their income could be eroded by inflation, while on the other, the value of their holdings could fall sharply when interest rates do start to rise.

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So, as the financial industry becomes increasingly concerned about 2013 and whether investors have puffed up the bond market into a bubble, the warnings are becoming more frequent and more shrill.

Arthur Steinmetz, chief investment officer for Oppenheimer Funds says he wants to send a blunt message to investors who are flocking to buy bonds with meagre yields.

People, out of fear, are getting poor slowly. I’d like to dump a bucket of cold water on these people and saythink about it! Consider the consequences of your choice’.”

More than $2tn has flowed into fixed-income funds globally over the past four years, according to JPMorgan, with equities receiving an allocation of barely $400bn. In the past two years, equity funds have suffered outflows, even as the S&P 500 has risenfitfully – by 8 per cent so far this year.

Across the developed world investors are willing to accept low income in return for the perceived safety of portfolios anchored primarily in government paper and other bonds that will return their principal. However, the yield on the benchmark 10-year US Treasury is below the rate of inflation, and there are negative real yields in Germany and the UK, too.

Investors are still worried by the volatility roller coaster they see in the equity market,” says Andrew Lo, professor at the Massachusetts Institute of Technology. Investors, and in particular retirees, feel they have little choice but to go into bonds.”

The average yield on investment-grade US corporate debt has fallen from 5.9 per cent in 2007 to 2.67 per cent today.

What is missing, argues Seth Masters, chief investment officer for asset allocation at AllianceBernstein, is a long-term perspective. He says short-term thinking and fear has inflated a “safety bubblepushing up the price of assets across the fixed income markets while boosting supposedly low-risk dividend stocks, as well.

He likens it to the dotcom bubble more than a decade ago but says it will be more painful when it bursts this time because of investors’ belief that bonds are safe.

The current rush for bonds only makes sense if the US and other Western economies are set to spend many years experiencing lacklustre growth that keeps yields anchored at or near their present low level. Even then, such a scenario is hardly uplifting for retirees, savers and pension plans, as at best their returns from meagre bonds yields entail a much lower standard of living.

Mr Masters says starkly that a bond portfolio will not provide enough income to cover a retirement that just might last 30 years.

“The risk of ruin at that age, it sounds dismal to me. Yet the risk of ruin after 30 years approaches 100 per cent if you are a typical American and if you have a portfolio in bonds right now.”

Central bank policies bear a lot of responsibility for a creating an environment that is so tough for savers.

It is four years since the Federal Reserve enacted an emergency rate of borrowing, slashing their key overnight lending level towards zero per cent. It’s a policy stance in conjunction with three rounds of bond purchases, known as quantitative easing, that has dramatically reduced the interest paid out on savings accounts across the country.

“The downside of low rates for savers and retirees is something the Fed doesn’t talk about,” says Jack Ablin, chief investment officer at Harris Private Bank. Mathematically, there is very little room for error in bond land.”

Four years ago, a US retiree or saver could gain at least 4 per cent by placing their money into a certificate of deposit for five years. This year, the national average rate touched a low of 1.3 per cent according to Bankrate.

US government bond yields are also a benchmark for other interest rate markets around the world, thanks to the dollar’s status as the world’s reserve currency. As such the so-calledrisk-free ratecommonly afforded to US Treasury yields is now seen as sending a distorted signal. By pushing Treasury yields so low, the Fed has in effect pulled rates for riskier bonds down too.

But this has not stopped investors stocking up on riskier and riskier debt as the year has progressed, from longer-dated corporate bonds to junk bond funds, at least until a modest pull-back in the past month.

The reduction in yields to levels not seen since the 1950’s worries many seasoned investors who fear capital losses if interest rates start to rise. Higher rates have always been a risk of bond investing – a bond paying 4 per cent will be worth less if the prevailing rate moves to 5 per cent – but by buying at very low rates the effect is more marked.

Consider $1m invested in 10-year Treasuries. The asset manager MFS calculates that if bond yields rise from 1.75 per cent to their long term average of 5 per cent by the end of 2017, adjusted for inflation the investment will be worth just $690,000 in today’s money, a real loss of about 7 per cent a year.

The rise in rates may not be slow and steady, though. As the economy improves, producing stronger growth and rising inflation, the Fed is likely to wait before tightening monetary policy so as not to damage the recovery. But the bond market will quickly price in the risk of higher rates, led by a jump in long dated yields. For investors holding bonds with a long maturity at a low fixed rate of return, such a scenario would strike hard.

“When interest rates are near zero, it should loom much larger in your perception of risk than it does for most investors,” says Mr Steinmetz. He does not expect the Fed to raise interest rates before 2014, or 2015, but cautions that signs of healthy economic growth could prompt rates to move in anticipation.

Market participants will immediately start talking about the Fed being behind the curve.”
Since 1994 – the last time that the Federal Reserve surprised markets with the aggression of its rate rises, causing severe losses for investors – the size of the fixed-income market has expanded enormously. Potentially compounding a rush for the exits is the proliferation of exchange traded funds which adjust their portfolios much more quickly than mutual funds do.

“We spend a lot of time worrying about the bond unwind,” says Michael Kastner, managing principal at Halyard Asset Management. “A lot of money has piled into the sector and will go in the opposite direction at some stage, they are clearly in bubble territory. Everyone in bonds has the same idea that they can get out before others when the market turns.”


The danger for those investors, and for the asset management firms that happily sell them every variety of bond fund, is that they are piling into fixed income when it has reached the end of the road. Investors burned by the dot com bubble, the 2008 crash, and then losses on their supposedly safe bond funds may have little trust left for the industry that helps them to save.

Even so, there remains the question of timing. Warnings about a turn in the bond market have been commonplace for a decade even as bond yields have fallen ever lower. For all the angst that low yields and flows into bonds at the expense of equities currently arouse, some argue a change is well over the horizon.

Megan McClellan, US head of fixed income at JPMorgan Private Bank, does not believe a denouement will come soon and says that when yields on fixed-income do finally start rising, the trend will be tempered by demand from investors who are not yet in the bond market. “We have got a lot of people in cash on the sidelines waiting for rates to go back up. If rates rise, you could see a second wave shift into fixed income,” she says.

Such demand may be far from temporary. Rick Rieder, chief investment officer for fixed income at BlackRock, pictures a world of slow growth where demand for secure debt outstrips supply and keeps rates low for the foreseeable future.

“We have never seen in history the population ageing and living longer in such a fashion, not just in the US but around the world, and that raises the question of how high growth can go.”

At the same time, he says, “we are in the midst of a major deleveraging in the entire developed world, which is going to continue in 2013 and 2014”.


A perceived supply-demand imbalance bolsters the bulls’ case for staying in bonds. It is one of the reasons for negative yields in core European countries such as Germany, where bunds are in extra demand now that the bonds of Spain, Italy and other crisis-hit countries have been taken off the list of “risk freeassets that markets can use as collateral.

In the US, swaths of bonds issued in the debt boom before the financial crisis are maturing and net new supply is meagre. RBS calculates that the supply of Treasury and government-backed bonds and investment grade corporate debt will increase by $1.16tn next year, but that the Federal Reserve will buy up $1.02tn of it, leaving a net $138bn for investors around the world.

For all the warnings, such inflows have been vindicated so far. Late last week, US corporate bonds have returned 10.2 per cent year-to-date, while high-yield or so-called junk corporate debt is up 12.8 per cent according to Barclays indices.

Mr Kastner says: “Retail investors like to chase recent performance and corporate bonds still look good, great versus cash and respectable versus stocks.”

Given a sluggish economic recovery investors can be forgiven for their bond preference based on recent history, say some asset managers.

“If you look at the last 10 years, corporate bonds have had a higher return than equities with a third of the volatility,” says Mark Kiesel, portfolio manager at Pimco. Investors are looking at earning 4 to 6 per cent from a diversified portfolio of corporate bonds and that’s roughly what you will get from owning equities based on the outlook for earnings and the economy.”

The defeatists could even agree with David Wright, head of Sierra Investment Management, who says predicting movements in the bond market is a mugs game. If there was anyone on the planet who had a decent record predicting turns in interest rates we would all know their name. There is no guru on interest rates.”

Copyright The Financial Times Limited 2012.

A Green European Budget
Jacques Delors
18 November 2012


PARISHowever predictable the difficult negotiations that accompany European politics may seem to be, in the end they seldom fail to surprise. A crucial European Union summit aimed at securing a deal on the EU budget for 2014-2020, the so-called multi-annual financial framework (MFF), will take place later this week, and the mood music surrounding it has been intense, to say the least.
Before even a word has been spoken, Europeans are being told that the negotiations in Brussels will be bad-tempered,” with vetoes by individual member states looming large. Unfortunately, such talk could well become a self-fulfilling prophecy.
Consider this: A group of major companies based in various EU countries – the likes of Tesco, Shell, Barilla, and Philips – are insisting that whatever its final size, the MFF deal should commit to a proposed minimum of 20% of spending in 2014-2020 on green and low-carbon growth. These are the same companies that Europe’s national governments court and listen to on a daily basis. But, when it comes to the MFF, Europe’s national leaders appear not to be listening closely. Nor do they say much about the obvious dividends that such spending could provide, from the United Kingdom in the west to the EU’s newest candidate country, Croatia, in the east.
Europe’s 500 million citizens may not be surprised by what is playing out in the corridors of power, but they ought to find it very disturbing. The issue is not only what could be lost in the race to the bottom in which many EU national governments are now engaging, but also the manipulative anti-EU sentiment coming from many quarters of the European press, which appears intent on pushing various national leaders into another budget showdown.
In the EU’s western, net-contributor states, the MFF debate remains narrowly focused on how much money can be cut from the European Commission’s proposed €1.033 trillion ($1.3 trillion) budget for 2014-2020. Next to nothing, though, is being said about the Commission’s more important, and more integral, proposal: the 20% spending commitment.
The dividends promised by a greenMFF (which recently received the support of the European Parliament) are at least threefold: a higher share of jobs in one of the world’s fastest-growing economic sectors; lower energy bills for households throughout Europe; and help in achieving the reductions in greenhouse-gas emissions to which all EU states have agreed as part of their Europe 2020 commitments.
The green potential within EU spending has already taken root. In France, for example, social housing organizations have rapidly deployed €320 million of EU money in the last few years to improve energy efficiency in existing housing stock. This European finance triggered additional investment of €2.2 billion, created 15,000 local jobs, and has resulted in savings of €98 per month per household, thanks to a 40% average decrease in heating costs.
Recently, Michael Heseltine, a former minister in Margaret Thatcher’s government, stressed the importance of wind energy for deprived regions of the United Kingdom, such as the northeast of England. And yet the penny has not dropped in London that focusing European investment funds accordingly would create opportunities to build stronger businesses and increase competitiveness in the technologies of the future – and to share these gains within and beyond the EU. Instead, in the UK and elsewhere, the predictable MFF chest-thumping that is now underway threatens to dispatch this kind of opportunity to the bin beneath the negotiating table.
Europe has come a long way since 1951 and the creation of the European Coal and Steel Community, the forerunner of the EU. But we are now in the process of constructing the EU economy anew, striving to overcome the economic crisis, and creating a more sustainable, globally competitive, and resilient European economy – an economy that can be green as well as productive.
The EU’s heads of government need to understand the bigger picture as they prepare for this week’s MFF summit. Europe’s common good – indeed, its most promising path to a prosperous future – is at stake.

Jacques Delors, a former president of the European Commission and a former French minister of economics and finance, is founding President of the Notre Europe – Jacques Delors Institute.

November 18, 2012 8:24 pm
What not to worry about in the euro crisis

When things get complex, thinking gets muddled. There is still a lot to worry about in the eurozone crisis. But it is just as important to understand what not to worry about. So here is my brief and imperfect attempt to bring a little simplicity and a little clarity to the ongoing eurozone crisis.

My list of things not to worry about contains five items. The first is France. The Economist last week appeared to pass the honorary title of “sick man of Europe” to France. I think this is wrong. The relatively robust growth during the third quarter was a fitting example that France is often more resilient than forecasters and commentators generally acknowledge. The French economy has had a relatively good crisis and has often defied negative expectations, especially from commentators who view the universe from a perspective of competitiveness alone. I suspect that the currently fashionable French-bashing is politically motivated – a rightwing reaction against a Socialist president. I am wondering that if France was really an economic basket case, why did so few people say so while Nicolas Sarkozy was in power? What reforms did he make? In 1999, by the way, The Economist awarded the title of “the sick man of the euro to Germany.

The second is competitiveness– I dealt with it in part last week. Let us define it here as cost competitiveness. It is true that Germany has gained competitiveness over the past 10 years, when defined in terms of how much output is produced given the wage of a worker, but this process is already reversing. This year, unit labour costs will increase by 3 per cent in Germany, and fall by 8 per cent in Greece, according to a senior European official. An 11 per cent adjustment is a big deal. Spain, too, is adjusting.

The third thing not to worry about is extremist political parties. They exist, of course, and they have become more popular. The rise of the far-right Golden Dawn party in Greece is troubling, of course.

But I do not expect extremist parties to alter the course of eurozone politics. The recent election in the Netherlands strengthened the political centre ground, despite the country’s deep recession. In France, the National Front had a good result in the presidential elections but Marine Le Pen, its leader, did not make the second round. In Italy, the Five Star Movement, the comedian Beppe Grillo’s anti-eurozone party, occupies second place in the polls. But it will be easily outflanked in the April general elections. And the only political innovation in Germany is the Pirate party, who are delightfully silent on the euro.

Fourth on my list is the German constitutional court. The legal issues involved in the eurozone crisis management are hugely complex and many good proposals cannot proceed for legal reasons.

But the real constraint is political, not legal. If Germany rejects fiscal transfers, or debt writedowns, it will be due to a lack of political majorities, rather than the court. Its latest ruling on the European Stability Mechanism, the bailout fund, shows that this is a court that barks, but does not bite.

And finally, I am not worried about the next tranche for Greece, or for that matter, the one after that. Yes, watching this is all very nerve-wrecking. A two-year extension of the Greek programme costs some €32bn, and they have yet to “find the money”, as one official put it. In my years in Brussels I have learnt never to underestimate the ability of European technocrats to find money. They will stretch the loans, reduce the interest rate and construct a hugely complicated, transparency-obfuscating special purpose vehicle if they need to. If they do not find the money, they will find half the money for half of the time, and go back next year and look for the rest. I am not condoning the strategy, on the contrary. I am merely saying that they will find the money.

With this list of things not to worry about, it is now easier to focus on what I do worry about. The first of those, and the most important, is the impact of austerity on growth. 2013 promises to be an awful year for the eurozone economy that could well derail the current strategy.

The second on my list is the continued failure to resolve the crisis, and accept the inevitability of an official sector involvement in a future Greek debt restructuring – or direct transfers. Pushing resolution beyond the German elections in September next year is bordering on the insane.

And finally, the banking union faces further delays and is now subject to a lack of ambition. It will have no positive effect on the crisis because it will not separate the banks from their sovereigns, and contains no power of resolution and no deposit insurance. The debate has degenerated into a typical inter-institutional fight about who gets to do what.

As you can see, my list of things not to worry about is the longer one. This is not a return to optimism no danger here. It is a plea to focus on the few things that really matter.

Copyright The Financial Times Limited 2012