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Last month's bond market sell-off is, so far atleast, clearly more about rising interest rates than credit quality. Blame apparently rests with the Feds hintsabout QE tapering or the winding down of its more than $1 trillion annual bond buying. An examination of the various Bank of America Merrill Lynch bondindices’ May performance, in order of credit quality, clearly shows the lowestquality bonds outperformed those of higher quality but longer maturities:
London based Capital Economics suggests rates will settle down. Inflation is low and growth still tepid, so no need to rise as much as in, say, 1994. That year, the Feds surprised everyone by raising their fund’s rate 300 basis points in 12 months. A bond market rout and the "Tequila Crisis" ensued, where Mexico was eventually bailed out. However, there is no Fed surprise this time.
So a sudden collapse is unlikely but it is probably worth noting the last time equities yielded more than bonds was the late 1950s,which was the beginning of a multi-decade bond bear market. We wondered, with US Treasury yields the main reference for asset pricing, what could possibly be in store for, well, everything else now that rates are on their way up.
Perhaps one of the main lessons from the late 1950s is that equities, given enough time, will most likely provide superior real after-inflation returns. Post-crisis growth rates may be sub-par for a while yet, but a disciplined and contrarian approach to stock selection offers a good way to profit from market turbulence. The complete melt-down of junior gold miners, compared with massive outperformance of similarly risky biotech shares, possibly demonstrates one such opportunity today.
In fact, disciplined behaviour is always a good strategy. A fascinating discussion paper from the Federal Reserve came out in late 2012, which looked at the herding behaviour of institutional bond investors.* The authors found a strong and statistically significant tendency for bond investors to follow each other, typically buying new issues and selling near maturity dates. Credit events also showed herd behaviour, especially in lower rated and less liquid paper.
The interesting part was the equally strong outperformance of these same bonds once the mass selling was over. The recent bond issue by Apple Inc. is instructive: 3 times oversubscribed at issue, it is now down more than 9% in the last 6 weeks. According to Bloomberg, investment dealer bond inventories are more than 80% lower than before the crisis, so market liquidity is much lower and prices can fall sharply, as Apple’s bonds recently demonstrated.
In our view this is a clear opportunity for an active and hedged approach to investing in credit markets. The HFRI RV Credit Multi-Strategy Index gained 1.7 percent in May. Well managed credit hedge funds are often liquidity providers in turbulent markets, which combined with good credit work, allows for profiting from the herd. This has not gone unnoticed as many of the large credit hedge funds are closing to new investors. Though the best way to protect and advance capital in this environment would seem to be smaller,nimble but established hedge funds that can trade with little market impact.
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