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Bond volatility fell to historic lows in the wake of the financial crisis, but it has begun to rise once again. James McAlevey explores the implications for investors.
After a long period of calm in the global markets, volatility has made a comeback at the beginning of 2018. Stock markets dipped sharply in the second week of February and the CBOE VIX index – the so-called ‘fear gauge’ that tracks equity volatility – spiked higher than it has been since 2015.1
What has received less attention is that bond volatility also started to rise, albeit less dramatically, in early February. The 10-year US Treasury VIX Index (TYVIX), which tracks the volatility of the eponymous securities over a 30-day period, reached its highest level since April 2017, as did the Merrill Lynch Option Volatility Estimate Index (MOVE), which offers a gauge of expected price swings in US debt by measuring implied volatility on one-month Treasury options.
These movements may herald the beginning of a profound shift in market dynamics. A prolonged period of calm followed the financial crisis, as central banks held interest rates low to support the economic recovery. But as extraordinary monetary policy is withdrawn we are likely to see volatility normalise at higher levels, bringing new risks and opportunities for bond investors.
Turning of the tide
Several factors kept a lid on volatility in the post-crisis period. As well as low interest rates, quantitative easing exerted downward pressure on yields; while strong demand for government and investment-grade corporate bonds among foreign investors also helped dampen volatility. But now these forces are beginning to reverse.
Part of the reason for the market ructions in early February was the news of stronger-than-expected US wage growth. This prompted speculation the Federal Reserve may need to hike interest rates more quickly than expected under its new chairman, Jerome Powell, to tame rising inflation. The Fed last raised interest rates on December 13, when the outgoing chair Janet Yellen announced a 25 basis point rise in the target range for its overnight interest rate to 1.25-1.5 per cent.
Central bank policy is also shifting across the Atlantic. On November 2, the Bank of England raised the official bank rate from 0.25 per cent to 0.5 per cent and signalled its intention to implement two more hikes before 2020. We may also have reached peak accommodative policy in Japan and Europe, with the Bank of Japan and the European Central Bank likely to gradually reduce their extraordinary support in 2018. The net result is the removal of a hitherto reliable structural buyer from the market, which changes the market dynamic drastically.
Changes to the internal dynamics of the bond markets may also play a role. In the post-crisis period, foreign institutional investors were influential – and often indiscriminate – buyers of bonds in the US, whereas domestic investors such as pension funds are now the dominant players. Because they are more sensitive to price fluctuations, these institutions are more likely to buy and sell their holdings, which could lead to higher volatility in fixed income.
As the structure of the market shifts, a lack of liquidity may also prove to be an issue. Regulation introduced in the post-crisis period forced banks to hold a greater proportion of high-quality liquid securities on their balance sheets and to post the bonds as collateral on derivatives trades.
While this new regulation boosted demand for fixed income, it led to a decline in liquidity. Banks have reined in their market-making activities and are now less able to act as shock absorbers during periods of stress. At the same time, the rise of electronic trading has increased the risk of sudden ‘spikes’ in illiquidity in US Treasury markets, making them potentially more volatile, according to research from the Federal Reserve Bank of New York.
The US central bank may further contribute to volatility as it begins to wind down its purchases of mortgage-backed securities (MBS). The Federal Reserve started buying these bonds at the height of the crisis in 2008 and has since amassed an MBS portfolio worth US$1.77 trillion. Many of these bonds are likely to re-enter the private markets in 2018.
MBS as an asset class has what is known in investment jargon as ‘negative convexity’, which means these bonds are particularly sensitive to changes in interest rates (as the life of mortgage debt tends to get longer as interest rates rise). Investors in these bonds often hedge the attendant risk by buying options against such movements, helping to lift the ‘market price’ of volatility. In 2003, so-called ‘convexity hedging’ was the key driver behind a rise of 1.45 percentage points in benchmark Treasury yields over a two-month period.2
These factors will not in themselves be enough to lift fixed-income volatility. But they may remove some of the pressures that have kept volatility low since the financial crisis. This means a monetary policy shock – such as the fears over a more-aggressive hiking cycle we saw in early February – or an economic or political catalyst, is more likely to send prices higher or lower, whereas previously such developments left investors unmoved.
The populist threat is bubbling beneath the surface across swathes of Europe – the Italian general election in March is a potential flashpoint – while 2018 will also see a number of key elections in important emerging markets. Populist victories in these votes could prompt greater volatility in some fixed-income markets.
The Chinese economy is another potential concern. China is attempting to transition to a more open, service based economy. This is a delicate process and there is a risk policy mistakes might lead to a sharp slowdown in growth, with wide-ranging effects across global markets, although this is not our core scenario.
So how might higher fixed-income volatility manifest itself? And what degree of volatility should investors expect?
As of February 9, the MOVE index stood at 71.78, its highest level since April 21, 2017. As a base case, we expect volatility to normalise at somewhere close to its 1990s range, perhaps between 80 and 120 on the MOVE index, following the extreme highs of the crisis and the extreme lows seen in the run up to the crash and thereafter.
In this environment, investors need to ensure their portfolios will remain resilient in the face of market gyrations. Firstly, they should be mindful of the duration of the government and corporate bonds they own. Because long bonds are more sensitive to rising interest rates, they are more vulnerable than short-maturity bonds when yields rise and volatility picks up.
But investors can also look to turn increased volatility to their advantage. The market price of volatility continues to trade at a low level despite the recent changes in market structure, which could present a lucrative opportunity for investors to buy options that pay out when volatility rises.
Investors should also be aware that a rise in volatility is likely to be accompanied by a breakdown in bond-market correlations. During the period of low volatility, correlations were strong, meaning the resilience of issuers’ balance sheets – as well as other factors such as their geographic location and the regulatory regime they fall under – were all but irrelevant to bond pricing. This favoured passive, beta-driven strategies based on simple market exposure.
But as central bank liquidity is withdrawn, fundamentals will come to bear on valuations once again, and may expose weaknesses in riskier parts of the market. Using credit derivatives to buy protection on sectors in which valuations are currently out of step with fundamentals – such as oil and gas, and autos – while selling protection on the wider index offers a way for investors to profit if these bonds reprice relative to the market.
There is no free lunch in bond investing. But since losing money with a traditional long-only bond portfolio in a rising rate environment is a mathematical certainty, investors should start preparing for a return of volatility and a breakdown in correlations in 2018.
1. ‘Volatility expectations swell’, Financial Times, February 6, 2018
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