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Timing is everything in bond investing as yields constantly rise and fall, says portfolio manager and seasoned market watcher Olaf Penninga.
His Lux-o-rente global bond fund uses a sophisticated quantitative timing model that predicts movements in bond yields, making it possible to invest more in good times when bond yields decline, and pull back when markets turn.
“We have had a spectacular start to 2016, with already 1% outperformance in the first three weeks of the year,” says Penninga. “This really shows again the importance of timing. People say ‘yields are low, and why should we still hold bonds; maybe it’s time to pull out’. But what you see is that you can still make money in these markets providing you can do the timing. Yields are low, but they are not stable – they are moving a lot.”
“Yield changes are more important for bond returns than yield levels. German Bunds returned more than 10% in 2014, although the 10-year Bund yield on average was just 1.2% in that year. Timing these yield changes is key to generating returns. Over the existence of the fund since the 1990s we have demonstrated the ability to benefit from falling yields and to protect against rising yields.”
Lux-o-rente invests in a global government bond portfolio and strongly adjusts its duration positioning versus its benchmark. Decisions about duration positioning are fully based on Robeco’s proprietary quantitative market timing model.
Although yields are at record lows, Lux-o-rente currently has a maximum duration position of 13.5 years – partly because the equity market has been tanking in the first weeks of 2016 on economic fears. Government bonds are often seen as a ‘safe haven’ away from volatile stock markets, reflecting an old adage that ‘bad news is good news for bonds’.
“Lux-o-Rente is long and strong; we are positive on all bond markets at the moment,” says Penninga. “In equity markets, people are worried about growth, and commodity prices are dropping again, with even lower inflation expectations, and these factors make the model quite positive on bonds. Lagging economic growth and low inflation expectations make central banks cautious in tightening their monetary policy, such as the Fed, or make them consider increasing stimulus, such as the ECB and the Bank of Japan, and that’s all good for bond markets as well.”
‘We are positive on all bond markets at the moment’
“We are at our maximum duration overweight, so this is the maximum positive positioning that we can have. What is special about Lux-o-rente is that most funds tend to be relatively close to their benchmark and say they have room to go overweight but don’t always use that ability. Lux-o-rente is often at its maximum or minimum duration position rather than being at the benchmark.”
“It is a truly active global approach, and that is what you need in the current bond markets. Being passively involved in bonds is not that rewarding. You need to be truly active to capture opportunities across the globe.”
Penninga says the direct implementation of what the quantitative model is predicting is critical for success in constantly moving markets, as was shown in 2015. “In the first part of last year, bond yields fell, so bond prices performed strongly; then there was sell-off and then again a strong return,” he says.
“If you were passively invested in bonds you would have seen a lot of volatility and hardly any return. But by being able to use timing, we are able to generate strong returns at the start of the year, protect ourselves during the sell-off, and then benefit again in the second half. With this type of timing ability you can still make money to benefit from the stronger quarters and protect against the weaker quarters.”
This was seen in 2015, when the fund returned 3.0%, significantly outperforming the 1.05% achieved by the benchmark, the J.P. Morgan Government Bond Index Global Investment Grade (hedged into euros).
The risk of future Fed rate hikes causing bond values to fall can be worked around, provided you can look at the whole market, and take a global approach, says Penninga. “Even if the Fed hikes again, that would raise short-term yields, but it doesn’t mean that long-term yields have to rise as well,” he says. “The last time the Fed hiked rates in 2005 and 2006 we had this famous conundrum where long-term bond yields didn’t rise, so a bond return need not be negative.”
“And when returns sometimes are negative, such as in the second quarter of last year, which was the worst calendar quarter in 20 years, it was surrounded by good calendar quarters with good returns. It doesn’t make sense to simply shy away from bond markets completely; you need them for your portfolio for diversification so that you can really benefit in periods when bonds are performing well. It’s like having an airbag in your portfolio.”
‘It doesn’t make sense to shy away from bond markets completely’
And investors should look at the global picture, particularly given the dislocation between the US, which is tightening monetary policy, and Europe, which is still easing it. “It’s great that we have a global approach, especially since bond yields are higher in the US than in Germany and so in times of stress, US bond yields can fall much further,” he says.
“In Europe, everyone already discounts the fact that inflation is low and the ECB will ease, but in the US, people are now expecting rates to rise over the coming years, so there is much more room for expectations to be adjusted in the US than in Europe. So bonds have much more room to rally if things turn sour in the US, and with a global approach, we can benefit, both from the yields available in the US, and the potential for those yields to fall.”