NZ bond managers are up for an interesting year ahead as the recent spike in long-term rates challenges portfolio settings, creating scope for a wider spread of returns.
Hamish Pepper, Harbour Asset Management fixed income and currency strategist, said bond investors would have to act with “greater conviction” amid rapidly changing market dynamics.
“If you think yields are going higher, you need to be sure of the catalysts for that to happen and for those changes to happen quickly,” Pepper said. “It’s a tough market now – the risks are more balanced and there’s greater potential for divergence in outcomes.”
Last week the 10-year government bond rate rose about 40 basis points to hover around 1.8 per cent (after peaking above 2 per cent) despite a dovish Reserve Bank of NZ (RBNZ) monetary policy statement: last September the same bellwether financial gauge sunk below 0.5 per cent as the central bank and investors braced for a COVID-related economic crash.
In a sharp turnaround from last year when the prospect of the RBNZ taking the OCR negative was on the table, the market is now betting a rate hike is looming – regardless of assurances otherwise by central bank governor, Adrian Orr.
“All expectations of a rate hike have now been brought forward,” Pepper said.
However, he said the question for fixed income investors is whether the jump in long-term rates last week (mirrored across the world) was a “knee-jerk” reaction or an appropriate positioning for a more entrenched regime change in bond markets.
“The next debate will be at what point do we look at longer yields,” Pepper said. “As an asset class there may be some value now in long bonds as a diversification tool. When yields were 0.5 per cent it was hard to make that argument but at 2 per cent there could be some attraction.”
David McLeish, Fisher Funds head of fixed income, also said at current highs managers could be tempted to “add back some duration” that many have dialed back over the last six months or so.
McLeish said Fisher, for example, lowered the average duration of its NZ bond portfolio from 5.6 years at the end of last September to 4.8 years by February this year while also increasing credit exposure 5 per cent (to 25 per cent of the strategy).
He said the Fisher local fixed income portfolio shift followed better-than-expected economic data emerging out of NZ in the latter quarter of 2020.
While reining in duration last year was a relatively straight-forward call for NZ bond managers last year, the situation now is “more complex”, McLeish said.
“The next three to six months could be very different from the following three to six months,” he said.
Most immediately, NZ is likely to record stronger growth and rising inflation, coming off the low base of the COVID-interrupted 2020. But medium-term risks could take the shine off any recovery and any further increase in long-term bond yields.
“To go further [than the most recent rise in 10-year bond rates] we would need to enter unchartered territory,” McLeish said. “There’s a bigger range of possibilities.”
Most importantly, fixed income managers will be scrutinising the data for signs of inflation over-and-above a one-off bounce from easing COVID conditions.
Whether “we really see inflation” over the next 12 months will determine if the recent blip in yields is simply another ‘taper tantrum’ or the beginning of an upward trend in bond rates, McLeish said.
“There are a lot of smart people on both sides of the argument,” he said.