What does the end of QE mean for bond investors?

Insight
21 September 2017
  • The US Federal Reserve confirmed it will unwind its $4.5trn balance sheet from October 2017
  • Structural shifts in bond market liquidity will be gradual but the impact on transaction costs will remain a concern 
  • Investors may want to consider long-term strategies focusing on lowering transaction costs and risk mitigation

With the Bank of England possibly gearing up to hike interest rates and the US Federal Reserve set to reduce its considerable $4.5trn balance sheet, investors may be asking what the end of loose monetary policy could mean for their bond investments.

On 20 September the Fed announced that from October, it will initiate a “balance sheet normalisation programme”, in a bid to cut back the significant book of assets it accumulated via its quantitative easing initiatives.

The move is likely to see the Fed allow $6bn of US treasuries and $4bn of mortgage-backed securities, to come off its balance sheet each month, in the final quarter of this year. 

The central bank’s accompanying statement showed few changes to its overall economic outlook, keeping interest rates on hold and noting that business investment “has picked up in recent months”.

Fed chair Janet Yellen also stressed that the bank does not consider its balance sheet unwind as an active policy tool; rather the Federal Funds Rate would remain the “go to” strategy. However, she also reiterated that if the economy suffered a “material deterioration” the Fed could resume reinvestment.

In Europe meanwhile, the European Central Back once again left monetary policy unchanged at its September meeting.  ECB president Mario Draghi’s rhetoric has remained pretty consistent, confirming that the Bank would continue its €60bn monthly purchase programme until December 2017 “or beyond if necessary”, and that its key interest rates would remain at their present levels for an “extended period”.

While the Bank of England cut interest rates to a fresh historic low of 0.25% in the wake of the UK’s Brexit vote it recently indicated that this backdrop is unlikely to last. At its own September meeting, the Bank’s Monetary Policy Committee, noted that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months”.

In Asia, Japan and China are also beginning to signal their own tentative moves away from record low interest rates and QE initiatives as global growth improves.  

As a result, investors are increasingly asking what the end of QE will mean for their bond portfolios. One key concern is what happens to bond market liquidity when the Fed starts to slowly shrink its balance sheet.

After all, over the past decade, QE has widely been credited as having been a significant driver of financial market returns and as a result the effect that tapering could have on the bond market is very difficult to predict.

To avoid generating instability, the pace of this change is expected to be gradual, leading central banks and investors alike to hope for a smooth and hopefully seamless transition.

What does less liquidity mean for bond markets?

AXA IM’s Head of Buy and Maintain, Lionel Pernias, highlights that lower liquidity in the system as a whole should increase the transaction costs of trading.

He explains: “This is particularly significant in today’s low yield environment because it means that transaction costs make up a larger proportion of available yield, which makes minimising transaction costs a key consideration in managing credit portfolios.

“Ultimately monetary tightening is a slow-moving theme. However, lower liquidity, higher transaction costs and historically low yields have generally forced a rethink of credit strategies.”

For investors, this is likely to mean that they should potentially focus on high quality fundamentals and “avoiding defaults will be crucial for building robust credit portfolios through this period of normalisation”.

He adds: “The natural liquidity profile of short-dated corporate bonds can potentially be a key way for investors to minimise transaction costs, as portfolios should have a proportion of their securities maturing each year. Another potential benefit comes from higher reinvestment rates of maturities and coupons as central bank rates rise”.

What can investors potentially do?

According to Pernias, there are many fixed income strategies which can possibly help mitigate the impact of structural changes in the corporate bond markets.

“This could mean moving away from tactical trading and adopting a low turnover approach to efficiently harvest the maximum amount of yield from the investment grade credit markets, while facing a potentially lower downside risk,” he says.

The outlook for bond markets remains solid

Despite these fears, investors should also be mindful that the SEB estimates there is currently $15tn excess liquidity in the world economy1, and liquidity tends to only be a problem when a major asset allocation event is triggered.

The long-term fundamental case for credit also appears healthy, according to Pernias: “In our view global growth is low but stable, inflation remains contained and central banks are raising rates very gradually. In Europe, we believe the technical picture remains positive with the ECB still buying bonds. There is also strong corporate debt demand, with new issues largely oversubscribed. Investment grade remains a solid asset class in our opinion, with the US market likely to produce better returns given the higher carry.”

Given this outlook, investors may want to position their bond allocation towards strategies that are more likely to succeed in the long term as the market cycle changes.

1 Financial Times, 13 July 2017, ‘Charts that matter: Central banks’ QE retreat still leaves plenty of liquidity’
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