Insights

Ardea Investment Management is a specialist relative value investor, focusing on non-directional opportunities within the global fixed income market. Unlike more traditional fixed income mangers, our investment process seeks to identify and exploit mispricing between assets with similar risk characteristics and does not rely on forecasts for the direction of interest rates or other macroeconomic variables to generate performance.

As such, instead of a traditional forecast for the year ahead, this note seeks to examine the key themes in the bond market today and the risks associated with each consensus view. While Ardea does not rely on forecasts of economic variables to drive investment returns, understanding the risks associated with the macroeconomic environment is an essential element of our approach.

The peak of inflation and central bank policy

The 2024 calendar year is widely forecast to mark the end of one of the fastest and most aggressive central bank tightening cycles in modern history. Central banks have been successful in bringing inflation down from its peak and investors are now turning their attention to the timing and size of potential interest rate cuts.

However, the task of reducing inflation from 4% to the popular 2% target will be a far greater challenge for central bankers than the journey from 9% to 4%, with rising geopolitical uncertainty, the high cost of transitioning to greener economies and buoyant labour markets continuing to fuel the inflationary fire.

Certainly, an escalation of conflict in Ukraine or the Middle East has the potential to drive energy prices back to and beyond the highs of 2022. This means that investors relying on central banks to cut interest rates by a particular margin or at a specific pace expose themselves to significant downside risk.

Rhetoric between central banks in the developed world has also started to diverge, with the European Central Bank and Bank of England, committing themselves to the fight against inflation, while the US Federal Reserve has adopted a more dovish tone.

The European stance appears justified after inflation in France and Germany – Europe’s largest economies – rose in December resulting in the first increase in the annual rate of inflation for the euro-zone since April 2023. This was driven by increases in the cost of food, alcohol and tobacco as well as the cost of services and a less pronounced drop in energy prices.

Globally, economic activity appears to be tapering, notably in Europe and it is reasonable to anticipate that bond volatility will remain high in this environment. How central banks navigate these stubborn last percentage points of inflation will significantly impact whether we experience an economic soft landing or a harder one and the trajectory of bond yields will undoubtedly be influenced by the outcome.

Rising net bond supply

Estimates produced by the Institute of International Finance suggest that global debt rose by $19.5 trillion during the first year of the COVID-19 pandemic and hit a record of $307 trillion during 2023.

While not solely government related, a large proportion of this growth reflects increased borrowings by governments to defend their economies from the impact of the pandemic and stimulate growth thereafter. Consequently, there has been a significant increase in net government bond supply.

Governments are issuing significantly more bonds to cover rising deficits precisely at a time when the main buyers – the central banks – are cutting back on their purchases, transitioning from quantitative easing (QE) to quantitative tightening (QT) and shrinking their own balance sheets. The cost of financing this debt has also become significantly more expensive.

The big question is: who will step in to buy these bonds? Looking beyond central banks, the other historically prominent buyers of developed market government debt have been Japanese investors and China. Japan and China are the largest foreign holders of US Treasury bonds, for example. However, Japanese investors no longer enjoy the same upside from buying overseas bonds and swapping them back into domestic currency for higher returns. Similarly, China’s demand for offshore bonds has decreased due to financial system stresses, particularly in the property sector, resulting from slower growth and increased risk aversion. Relations with US also have the potential to impact China’s appetite to buy and hold Treasury bonds.

This means that private investors will have to absorb a substantially larger proportion of this increased government bond supply. These investors are more sensitive to yields and prices compared to central banks, which were price-insensitive buyers.

Furthermore, in addition to the larger supply, rising uncertainty and increased volatility will prompt investors to demand a higher term premium. The term premium signifies the additional compensation required for holding a longer-dated bond rather than opting for a series of short-term bonds. This threatens the performance of longer-dated government bonds and could result in a dramatic steepening of yield curves, particularly in regions facing the heaviest supply such as the US, Europe and the UK.

It is perhaps worth noting that a “dramatic steeping of yield curves” would in fact be a normalisation with many developed market yield curves inverted on expectations of rising short term interest rates, future recessions and the hangover of central bank bond buying programmes.

Bond market volatility

Government bond and interest rate markets are in a new regime of structurally higher volatility. This reflects uncertainty around inflation and the path of interest rates at a time where the pace growth is beginning to diverge between different economies, and geopolitical tensions are rising.

However, an overlooked but fundamental driver of market volatility are the central banks themselves. For many years and certainly since the 2007-2008 financial crisis, central banks had been swift to intervene whenever market stress emerged, either in the shape of interest rate cuts or quantitative easing. These actions supressed volatility within the fixed income market and throughout the financial system.

Today, central banks are lifting interest rates to combat inflation and aggressively selling down pandemic era bond portfolios at a time when government bond issuance is expanding at a rapid rate. This has resulted in a fundamental change to the role of central banks from suppressors of market volatility to volatility amplifiers.

What does this mean for investors? A regime of structurally higher volatility means that for any level of bond yields, investors should now expect materially higher price volatility and therefore more variable returns. This creates a specific challenge for investors targeting (or requiring) a specific level of performance and the asset allocation required to generate that return.

Conversely, an environment of higher volatility creates opportunities for relative value investors at a time where traditional fixed income portfolios may struggle to perform, highlighting the benefit of including a relative value strategy within a portfolio of more conventional fixed income products.

Duration risk

A softening of inflation in the second half of 2022 prompted some investors to forecast that 2023 would be the “year of the bond” after a year of aggressive interest rate hikes and fixed income weakness. However, as we saw in the previous two years, bond yields moved higher for much of the 2023 calendar year and fixed income assets continued to underperform.

Duration based strategies have gone through a difficult period over the past few years due to low, zero and then rapidly rising bond yields. Since interest rates began to rise, longer dated government bonds in particular have suffered sizeable losses, with some markets still deeply in negative territory since the start of the pandemic.

For 2024 “bonds are back” may be the catch phrase as many investors are again calling for bond markets to perform in the coming year as the risk / reward improves with the consensus view that inflation declines, growth slows and central banks start cutting interest rates. In this environment fixed income duration becomes an attractive proposition for investors. The main risk to this outlook is that economies remain robust, inflation stays elevated, and volatility persists.

Furthermore, uncertainty about inflation and the path of interest rates introduces a more variable correlation between bonds and equities. This is particularly relevant for multi-asset portfolio managers because the composition of their fixed income allocations now matters a lot more. Historically, investors could simply rely on duration (government bonds) to diversify equity risk, but today that duration component is more volatile and has a more volatile relationship with equities.

Credit Risk

Corporate bonds have suffered the same upward pressure on yields (downward pressure on prices) as government issued debt, but investor demand has remained robust.

Perhaps this should be of no surprise. Central bank policy designed to control inflation has driven interest rates upward and bond yields in the developed world are near a decade high. So, if you are in the camp that buys into forecasts for a soft landing when higher interest rates begin to bite, investment grade credit makes a great deal of sense. Higher quality issuers should easily withstand a mild downturn in economic growth and any reversal of recent interest rate hikes should be good for fixed income investors… bond yields down, bond prices up.

But what happens if the forecast soft landing turns into a nasty fall, or some other variable causes a sell-off in risk assets like we saw in 2020 (COVID), or worse 2008 (GFC)?

Default rates are undoubtedly on the rise, with some sectors experiencing the highest monthly tallies since 2009. Rating agencies Moody’s and Fitch both forecast the US high yield default rate to reach 5% in the next twelve months, reflecting the cost of higher interest payments at a time when slowing economic growth threatens company earnings. Lesser rated companies and those exposed to variable interest payments will suffer if interest rates do not fall as forecast. Spreads and yields could rise.

There is a plethora of reasons why investors might increase their allocation to corporate credit at this stage in the cycle. Income remains key for many investors and corporate credit continues to offer a yield pick-up over government bonds and cash.

However, we believe that any increased exposure to riskier assets, fixed income or otherwise, should be accompanied by an increase in downside protection, in the same way a scuba diver may carry an additional air supply, or a motorsport team may install bigger breaks on their race car.

Conclusion: Relative Value Investing

Fixed income investors face a laundry list of challenges in the year ahead, and at the top of that list will be ongoing uncertainty. In such an environment it is increasingly important to not only diversify the source of investment risk, but also the style of investment risk.

A lesser known, but nonetheless long-standing approach to fixed income is Pure Relative Value investing. Pure Relative Value investing does not rely on conventional fixed income sources of return and is not impacted by the level of bond yields regardless of whether they are high, low, or even negative. Nor is it reliant on corporate credit risk or a fund managers’ ability to forecast the direction of interest rates. Instead, a Pure Relative Value approach focuses on pricing inconsistencies between closely related securities – it offers investors an alternative to traditional duration and credit strategies – a third lever.

The global fixed income market contains a very large array of securities that are explicitly linked to each other by well-defined relationships. In an efficient market, these securities would always be consistently priced with one another, but the fixed income market is not efficient. Underlying structural factors such as regulation, mandate restrictions and varying investor objectives cause market participants to transact for reasons other than profit maximisation. As such, we continually observe pricing inconsistencies between closely related securities that have very similar risk characteristics. These pricing inconsistencies can be isolated using a wide range of risk management tools, including derivatives, which strip out unwanted market risk allowing the strategy to generate positive returns regardless of the level of bond yields or the direction of interest rates. The Ardea Global Alpha Fund focuses on pure relative value opportunities within the highest quality and most liquid government bond markets. Our approach is duration neutral and excludes corporate credit, which provides investors a true alternative to traditional fixed income strategies – a third lever.