The impact on markets of Price-Insensitive Buyers of all types of fixed interest securities has been a big talking point over the past ten years. This unique type of investor has, rather interestingly, no return forecasts or expectations factored into their investment. It is worth looking at these types of investors carefully, because those who are prepared to buy assets without regard to their price, may also turn out to be investors who sell those assets without regard to price. So what is the possibility of these owners of fixed interest securities becoming Price-Insensitive Sellers?
As we concluded two weeks ago, this asset class is trading well above historical norms, is overvalued, over-owned and looks terrible in both absolute and relative terms when compared with other options such as equities and property. Many active global fundamental (and many would say sensible) asset allocators have reduced their exposure global fixed interest bonds and securities to very low levels and within that exposure have added strategic managers that are able to move quickly between the different sectors or select quality coupons or rates for sound corporate issuers and over-weight floating rate notes or similar short duration instruments as protection.
But what if these buyers don’t just stop being marginal buyers of these overvalued and over owned assets, but become indiscriminate sellers and take prices significantly lower and / or yields higher than their historical norms? GMO’s latest quarterly letter digs into this concept in some depth. Their first question is: who are these guys?
Emerging Market Monetary Authorities. These fellows, particularly China, have accumulated billions of US$ fixed income securities as they fought to keep their currencies low in the 2000’s. This has continued since the financial crisis but has rolled over in recent months. Since they peaked in 2014, China has seen its official reserves fall by about US$260bn,as they need to focus on domestic demand issues. This recent change in trend could continue indefinitely.
Developed World Central Banks. QE policies in the US have slowed, but the ECB and Bank of Japan have picked up the baton on bond buying. This group of price-insensitive buyers may only gradually become sellers.
Defined Benefit Pension Plans (particularly in Europe) and Insurance Companies. Any investor forced to buy 50-year inflation linked bonds at negative real yields can only be doing so because a regulator said so. Quite when (or even if) these guys become sellers is unclear.
Mutual Fund and Index-Driven Bond Managers. As money has poured into active and passive bond funds over recent years, fund managers have had no choice but to buy the underlying assets. This business is highly sensitive to short term performance and if we get volatility and negative returns, this money will pour out. In the last quarter, for example M&G has seen outflows of £3.5bn (14% by assets) from its flagship Optimal Income Fund and numerous fund managers, not least Blackrock (the largest), are warning about the lack of liquidity in this asset class.
One thing is for sure, market volatility (see chart above) can be expected to rise disproportionately once two or more of these fellows become Price-Insensitive Sellers. What was once a low volatility and cautious asset class has changed for a very long time. As active global fundamental (and many would say sensible) asset allocators, it is perhaps not enough to just avoid the asset class but attempt to make some money from this rising volatility, then using floating rate notes and short duration deposits once relative and absolute values return.
Fifty Shades of Bonds
