Boring Bonds?

  1. While the post-September equity market slump and the recent rebound in share prices have been the focus of most ETF investors’ attention, the last eight months have also witnessed some major turbulence in the fixed income markets.

    In this week’s feature for Index Universe we review the performance of selected benchmark fixed income ETFs since 1 September 2008, a period encompassing the Lehman collapse and subsequent equity market slump, as well as the more recent hopes for an economic recovery.

    Yield Curves Steepen

    One of the most dramatic fixed income market moves for decades took place in the months around year-end. With fears of deflation intensifying, interest rates cut to zero and promises of unbounded quantitative easing, investors flocked to buy long-duration fixed-rate government bonds.

    The US-listed iShares Barclays 20+ Year Treasury Bond ETF (NYSE: TLT) surged a remarkable 30% in price during the two months of November and December, equivalent to a drop in the US Treasury long bond yield from 4.4% to just over 2.5%.

    2009 has seen an equally dramatic change in sentiment, with TLT dropping over 20% so far, and the long bond yield back up to 4.2%.

    In Europe, the largest long-duration government bond ETF, the Lyxor EuroMTS 15+ Year (MTF.PA), which consists of sovereign issues from eurozone countries, has shown similar price trends, albeit ones smaller in scale. It hit €121 in price during December, before retreating to the current quote of around €111.

    This rise in long bond yields has resulted in a steepening of government yield curves, since short rates remain pegged at low or ultralow levels. The increase in yields has occurred despite central banks’ commitment (in both the US and the UK) to purchase government securities as part of their quantitative easing (“QE”) programmes. The UK central bank expanded its QE scheme two weeks ago, in a move seen by some observers as a renewed attempt to push UK government bond (gilt) yields down. In the US, Federal Reserve Chairman Bernanke’s stated ambition is to cap Treasury rates as a response to any deflation threat. Bernanke, however, is facing a stiff test, evidenced by the recent move higher in yields. Funding needs, which are estimated at a massive US$ 2 trillion in the US government bond market this year, pose the major challenge to his plans.

    According to the ETF issuers that Index Universe interviewed for this article, most investor interest in bond ETFs remains focussed on corporate and inflation-linked funds, and not on fixed-rate government debt. However, according to Dan Draper of Lyxor, recent fund flows are consistent with the trend of yield curve steepening; Lyxor’s April assets under management figures show net disinvestment from the EuroMTS 15+ year ETF, with investors heading into shorter-maturity bonds.

    At the very short end of the interest rate curve, the near-zero rates on cash have caused some reversal in the record 2008 asset flows to money market ETFs, as investors take their quest for returns elsewhere. Both db x-trackers and Lyxor, which operate the largest funds in this area, have seen some recent redemptions.

    Other investors have been taking an outright negative view on the direction of European government bonds, using db x-trackers’ short (inverse) iBoxx Euro Sovereigns ETF. According to Marco Montanari, head of fixed income ETFs at the firm, inflows to this fund in recent weeks have totalled €100 million. For investors seeking to bet on a future increase in inflation and interest rates, said Montanari, the inverse government bond ETF offers a chance to express their views without incurring the interest rate duration risk that would go with a longer-dated inflation-linked bond fun

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