Inflation fears start to rock rates

Published on 17 June 2021

Rates markets at the start of Q2 began to see the effect of inflation concerns, along with central bank responses. While the solution to inflation is to increase wages, says Eric Vanraes, head of fixed income investments at Banque Eric Sturdza, the temporary financing of private income is the existing stop gap.

The slope of the curve in European and US is starting to steepen. If spreads for credit are so low they behave as a proxy to government bonds, investment managers need to consider which fixed income instruments will offer the best returns in a potentially volatile environment without significantly increasing the risk profile of portfolios.

Dan Barnes: Welcome to Trader TV – your insight into trading for professional investors. I am Dan Barnes. Joining me today is Eric Vanraes, portfolio manager at the Strategic Bond Opportunities Fund and Head of Fixed Income Investment at Banque Eric Sturdza.

Eric, welcome back to the show.

Eric Vanraes: Thank you, Dan.

Dan Barnes: We’d like to discuss today what’s happening in the rates markets in the start of Q2. First of all, what sort of factors were affecting rates markets in that period?

Eric Vanraes: The first issue was inflation and inflation fears. The second issue was the behavior of central banks and first and foremost in the US because we saw many people talking about tapering. So inflation fears were a little bit exaggerated because the central bank said and a lot of fund managers said that it’s only temporary, but the figures were impressive and inflation fears are still a concern because nobody knows. The solution for the problem is higher wages. And we know that, unfortunately, higher wages are unlikely.

But in the US, the administration, Joe Biden and Janet Yellen send a lot of money to the American people, to individuals. So this huge amounts of money replaced increases of wages. So the big question mark today is, is the Biden-Yellen plan still in place? Will they still give money to people and this could generate inflation pressures. Or is it enough? And if it is enough, inflation will slow down and go back to normal levels. At the end of the day, the Fed will be obliged to decrease its asset purchases. But they are so afraid of the last taper tantrum infinity, so they are very, very cautious and I think maybe the best moment to prepare the markets for this event is the next meeting in Jackson Hole (Economic Symposium) this summer. Conclusion it means that the slope of the curves in the US and Europe started to cycle.

Dan Barnes: And what effect does that have then on European bond portfolios?

Eric Vanraes: It’s very difficult because government bonds are not attractive and you can lose money with high duration due to the steeper slope of the curve. And very high quality credits are unattractive because the spreads are so low that at the end of the day they behave like a proxy of government bonds. And on the other side of the universe, high yield is becoming very dangerous because spreads are too tight for the risk you take. And the correlation with equities is very high and we cannot exclude a correction in equity markets in the coming weeks or months.

Dan Barnes: So what are the challenges then that that creates in terms of portfolio management and management of liquidity?

Eric Vanraes: It’s a very difficult question because there is liquidity in markets, but it depends on the asset classes because you have only one big buyer that is a central bank and the market maker is a central bank. And it affects the secondary market, but also the primary market, because when you see a new issue, it’s probably bought at 60, 70%, maybe 100% for a few new issues by the central banks. So there is a distortion in the game and nobody understands very well what is iliquidity. In our view, liquidity is not an issue. But if you want to find a specific bond, sometimes it’s very difficult.

Dan Barnes: So how could asset managers that ensure that they were getting better execution for their investors and optimizing returns as well?

Eric Vanraes: Best execution is not the concern. We are all MiFID compliant and we seek firms delivering returns. We developed two different strategies. The first strategies, as I said before, is that high-yield is dangerous. But at the same time, there is a market that is not very well known. It’s hybrid-corporates. Non-financial hybrid-corporates excluding the banking sector because you buy subordinated debt, so rated triple B, but subordinated debt of very high quality corporates with an investment grade scenario.

We think that it’s a smart way to have a return with high quality and normally the high yields are a return, but high yields are risk, normally. So hybrid-corporates are probably a solution. Southern strategy spreads are very tight, but short term duration spreads are tighter than long term because the slope of the curve of spreads is steep. So the idea is when you have a corporate that you like, instead of buying the three, four or five year maturity, you by your own maturity, or a 10-year bond. But when you buy the 10 year bond, of course, you have higher duration. So you make kind of synthetic five year corporate bond buying the 10 year corporate, but hedging half of its duration through a short position in futures bund in Europe and treasuries in the US. So you decrease over duration, but you keep the spread duration of the long duration of the coporate.

Dan Barnes: That’s fantastic. Eric, thank you so much.

Eric Vanraes: Thank you, Dan.

Dan Barnes: I’d like to thank Eric for his insights today and, of course, you for watching. To catch up on our other shows or to subscribe to our newsletter, go to TRADERTV.NET.