Accessing opportunities in the rates market is increasingly challenging

Published on 14 July 2020

In the low rate environment with rate volatility ‘dying on the vine’ curve finding investment opportunities is very challenging in the government bond space, as spread trades become very directional bets on yields rising or falling. Competition in primary and secondary markets is also fierce and that creates challenges for portfolio managers and investment traders as they seek to access new issuance or liquidity opportunities.

James Athey, investment director at Aberdeen Standard, gives us his insights into accessing returns as rates volatility is ‘dying on the vine’, from using interest rate swaps to building closer dealer relationships.

Dan Barnes Welcome to Trader TV, I’m Dan Barnes. Joining me today is James Athey, investment director of Standard Investments. We’re going to discuss whether investment opportunities in the rates markets today and some of the challenges in accessing those opportunities. So, James, welcome back to Trader TV.

James Athey Thank you, Dan. Thanks for having me back.

Dan Barnes Can you tell us where do you see investment opportunities in the rates markets today?

James Athey I am glad you started with such an easy question. It’s tricky, I mean, it really is tricky. With a few notable exceptions, what we’ve seen in recent weeks is very much – rate volatility is ‘dying on the vine’. This is something that we’ve encountered many times over the last decade or so. A central bank policy becomes the only game in town. It really does lead to rate volatility being crushed, and that does reduce a lot of opportunities where monetary policy is on hold for long periods of time as we expect it to. What you tend to find is that lots of curve and spread trades, which are sometimes good, diversified a portfolio actually just become very directional, and so everything is a yields-up or yields-down trade. For me the interesting things you can look at, at the moment are the curve is steep for a start, because we’ve got rates very close to zero, but we’ve actually got a lot of government bonds supply. We’ve got a lot of monetary and fiscal stimulus at the same time, and that’s led to some steepness in yield curves. And if you choose to look at the five year point, where you’re a bit more protected by central bank policy, you can still pick up some steepness. And so using interest rate swaps, investing in the forward curve rather than the spot curve, you can find some quite nice steepness around the five year point across a number of different markets, which will behave like duration in a risk off move, but will roll very nicely in your favor and is therefore a bit more protected if we do see yields rising. So that’s definitely something I’m looking at, but beyond that, I think it’s very much a question of whether you think yields are going up or down. For now, I’m still pretty defensive on the outlook, so I’m quite happy to be long duration at this point.

Dan Barnes You mentioned swaps, do you see cash or derivatives as the best way to access the market?

James Athey Definitely one of the big situations that you have to face at the moment as a rates investor is government bond supply, as I mentioned before. We’re used to a lot of supply from certain countries over the last few years, but some of the countries we’re not used to so much supply, such as Germany, have really bumped up supply to fund their fiscal programs. Obviously countries like the UK and the US are really engaging in fiscal programs, the likes of which we’ve not seen for some time, if at all. So there’s a heck of a lot of bond supply to deal with. So if you are using interest rate swaps, for example, you can take away some of the upward pressure that you might expect to see on yields coming from bond supply. And that can be attractive if you want to be long duration. On the flip side, if you are worried about inflation and worried about what supply might mean for yields, then being able to sell government bond futures is quite an attractive way to profit from that. So it really does depend on your view and how you want to be positioned. But I think there are still opportunities across the whole suite of cash, bonds and derivatives.

Dan Barnes We’ve seen a number of issuances as being very oversubscribed. How challenging is competition in the primary markets right now?

James Athey Yeah, you have to be careful because unfortunately, whether we like it or not, the reality is that there is some gaming of the system. You know, if the guys who are running the books on behalf of the countries issuing bonds, if they’re doing their jobs well, then they will be allocating to the stronger hands, the real money investors, those investors who are buy and hold, rather than likely to be flipping bonds very quickly out of the auction. What that means, however, is that where the issue is attractive for one reason or another to hedge funds towards faster money, what they can do is they can put in for a larger order than they would actually want on the expectation that they will be sized down and receive something much smaller. And that just feeds off itself. If everybody starts to do that, you get these hugely oversubscribed books, where there will be a number of clients and investors in the book who, let’s be honest, if they were given the full allocation, they would be very uncomfortable and they would be sellers very quickly. So there is some noise around the size of books on that part. And also, I think as well, in this low rate volume world, it does lend itself to investment strategies or trading strategies around the auction itself. And again, that just encourages a bit more fast money participation. People happy to have a bigger allocation, knowing that they’re going to be flipping it very quickly out of the back of the auction. So that’s not something that we engage in. We don’t think it’s right or proper on behalf of our clients to be using the book, but it is something that you have to be aware of.

Dan Barnes And that has liquidity looking in the secondary markets?

Dan Barnes Yeah, that’s tricky. It’s definitely impaired. Not anywhere near the same degree that we saw in March and April, where there were weeks where even the most liquid instruments like US Treasuries were meaningfully more difficult to trade. And when you start to go into the lower liquidity end of the right spectrum, things like inflation-linked bonds in smaller markets like Canada, it was disastrous liquidity. So things have definitely improved dramatically since then. But I would not with certainly characterize liquidity as anywhere near normal, it’s definitely substandard, certainly if you need to do a decent size in smaller markets. And I think. There’s no better example, really, of impaired liquidity than looking at the FX market, which traditionally is by far and away the most liquid, and you’ll still find the bid offers. In my view, tempers are probably on average two to three times wider than what we call normal.

Dan Barnes As an investment manager, what can you do to ensure that you can actually reach those opportunities on behalf of your investors, despite those challenges in both primary and secondary markets?

James Athey The way that that process should be operated by the book runners, the banks that are managing the insurance on behalf of the issuers, and ourselves as a real money investment house, buy and hold investors, long term investors with good relationships with our banks and with our brokers built up of trust over a number of years in understanding how we operate our business – that does put us in this sort of happy camp of being at the upper end of allocations when it comes to these primary market events. So we should find that we’re among the best allocated to groups of clients when we put into these primary market events. Actually accessing liquidity in a lot of these government bond issues is not an issue really for us at all. That declined somewhat when you start looking at primary issuance from some of the smaller but still developed market and highly rated sovereigns, I’m thinking like New Zealand. Just the size of their bond market, therefore the size of each primary market event and the size of some of the portfolios that we run. We just need to consider that we will be a large part of the book if we put in for a huge trade in relation to our portfolio size. And so we have to manage the liquidity risks that we’re taking. And of course, that’s something we consider before entering a position.

Dan Barnes That’s been great. James, thank you so much.

James Athey Pleasure. Good to see you and thanks Dan.

Dan Barnes I’d like to thank James Athey for his insights today, and of course you for watching. To catch up on our other shows go to TraderTV.NET and ETFTV.NET.