Taper tantrums

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Taper tantrums

Bond investors breathed a sigh of relief in late October when the US Federal Reserve decided it wasn't quite ready to wind down its quantitative easing (QE) programme.

Yet nerves are likely to start jangling again before long, given the threat of varying degrees of turbulence across both bond and equity markets once the US Federal Reserve starts to reduce the bond purchases it makes through QE.

There could even be a bond market meltdown - and the effects are unlikely to be confined to the US.The Fed's October decision means investors must continue to play a waiting game.

However, it gives those worried about the impact of QE tapering on their holdings more time to protect themselves from the broad-based sell-off that many are predicting when tapering finally begins.

In equity markets, experts expect the sell-off to be brief, but the effect on bonds is expected to last longer.

The effect of QE, which essentially involves central banks 'printing' money to buy bonds, has been to keep interest rates down, reduce volatility and encourage greater investment in risky assets.

The UK version of QE has seen the Bank of England use £375 billion of 'new' money to buy gilts, driving up their price and sending yields spiralling to record lows.

At its meeting in late October the US Federal Open Market Committee decided, as it did in September, on a wait-and-see approach and voted to continue its $85 billion (£53 billion) a month bond buying programme. Yet it is possible the Fed's QE bond purchases will be reduced in coming months.

Tapering may begin when Janet Yellen becomes chair of the Fed early next year, though Yellen has already indicated stimulus is likely to continue into 2014. All this may seem rather inconsequential to some investors, particularly those with their eye on the long term. However, it's anything but.

Ultimately, if QE is withdrawn, it is because the economy is improving to the extent that the central banks no longer feel a stimulus is necessary,."
Haig Bathgate

Anyone who doubts that QE tapering will affect asset values and markets need only look at the record highs hit by the Dow and the S&P 500 indices in September, when investors were taken by surprise by the Fed's decision to maintain QE.

Earlier in the year, mere speculation that the end of QE was on the Fed's agenda prompted a sell-off in emerging markets as investors began to dump riskier assets. It's clear tapering will cause disruption.

The greatest impact will be on bond markets, where some £1.43 trillion could be wiped out in asset 'fire sales' as QE is phased out, the IMF has warned. In its bi-annual global financial stability report, it says markets have become riskier in recent months as investors have begun to adjust their positions in anticipation of QE tapering.

The most adverse scenario set out by the IMF as a possible outcome of QE tapering is a sharp rise in global interest rates and a period of turmoil in markets. But winding down QE would, on the face of it, be a positive development reflecting a more upbeat economic outlook.

"Ultimately, if QE is withdrawn, it is because the economy is improving to the extent that the central banks no longer feel a stimulus is necessary," says Haig Bathgate, chief investment officer at Turcan Connell.

"So while there will be some short-term turbulence, and highly geared companies' equities and bonds will be impacted, it is ultimately a good thing in the long term."

Short-term shock

The short-term impact could be somewhat different, however. The greatest fears surround bond values, as one might expect, given that tapering essentially involves the Fed reducing its bond buying programme. The problem is that through QE the Fed has been the biggest player in the bond and gilt markets, pushing down long-term interest rates.

Tapering will gradually drive interest rates back up and send bond values in the opposite direction. So when speculation began over tapering, many bond investors shifted towards the exit door, fearful of large losses.

Bathgate believes bond prices will sell off "very significantly". He warns that 10-year gilt prices could take a hit of up to 30% if interest rate expectations increase to the long-term average.

"We think the part of the bond market that will get hit hardest is high-yield bonds, and that the risk of a permanent loss of capital in these bonds is highly likely," says Bathgate.

"Defaults are at the lowest levels pretty much ever on the back of artificially low interest rates. When they start to rise, a large number of companies with high levels of borrowing in this sector will see their working capital dry up and [will] default."

That the bond market in particular faces turbulence - and possible liquidity problems - is the consensus among experts assessing the likely ramifications of QE winding down.

Action plans

So what can investors do to protect themselves from a broad-based sell-off?

Simply reducing fixed-income exposure as much as possible may pose more risks than it avoids, by unbalancing a long-term portfolio. Instead, the key may lie in picking the right fixed-income securities. Increasing weightings towards asset classes and sectors that have a relatively low correlation with mainstream equities and bonds is another possible strategy.

Gareth Howlett, director at Brooks Macdonald Asset Management, says there has been "intense internal debate" as to how best to protect investor portfolios in the event of a broad sell-off.

One thing he is confident about is that there's little appeal in holding long gilts to maturity, despite the rise in yields in recent months.

We think the part of the bond market that will get hit hardest is high-yield bonds, and that the risk of a permanent loss of capital in these bonds is highly likely."
Haig Bathgate

"Fortunately, the correlations are not perfect and we can take advantage of the fact that fixed interest is a diversified and global asset class," he adds.

"For example, higher-yielding corporate bond funds, where individual issues are close to maturity, offer a much better risk-reward trade-off than gilts. Floating-rate funds can also play a part."

The key here is the effective use of active management in blending different approaches to give the best chance of capital stability, a decent yield and a low correlation with equities. But as John Bell, chartered financial planner at Carbon Financial Partners, notes, fixed-income investment managers find it even harder to beat their benchmark than equity managers.

"Only 6% of US fixed-income managers were able to outperform their benchmark over 10 years to December 2011, and none managed it over 15 years," he says.

Investors should therefore ignore the QE noise and focus on an investment strategy to achieve their own long-term goals. Bell says research favours investments in higher-quality credit such as short-dated government bonds.

"In this area of the market it also makes sense to diversify across countries, maturities, guarantees, issues and credit ratings," he adds.

Safety in equities?

The case for equities is more robust, particularly with the natural alternatives to fixed income - most notably cash - lacking appeal in the current climate.

Alan McIntosh, chief investment strategist at Quilter Cheviot, says: "The last two times the Fed tightened, in 1994 and 2004, equities fell 5-10%, then rallied and carried on rising, while interest rates and bond yields rose. Tapering will occur because the economy is strengthening. This is positive for corporate earnings and equities, but negative for bonds."

Bathgate concurs on equities' attractions: "Equities will be hit hard initially, but we'd expect most to bounce back relatively quickly - unless, of course, they have high levels of borrowing," he says. "We're also expecting inflation to pick up quite markedly on the back of a sustained recovery, and equities are a natural hedge given their ability to pass on price increases."

However, there may be a sell-off among some better-quality companies, he warns, as the search for yield over the past four years has driven them to peak valuations.

"The fact that [Fed chairman] Ben Bernanke did a u-turn on tapering in September means it's more likely we will have a late 1993- or early 1994-style shock to the system, where bonds and equities sell off at the same time," he concludes.

Most advisers and fund managers are bullish about equities in the context of QE tapering, but they have voiced some caveats. One is that investors may benefit from looking for fundamental value and keeping an eye on asset classes where values have been inflated by QE over the past four years.

Howlett advocates looking at specialist investments in assets such as infrastructure, where the long-term cash flows from the underlying business are thought to be more reliable than those in the wider equity market.

"However, we need to be aware that valuations are not as cheap as they were, and also that they may underperform in capital terms if markets decide we are in a rising growth/rising inflation environment," he says.

"Commercial property (excluding London) is another area starting to look interesting," McIntosh suggests.

There's also an argument for investing for recovery and for banking on a rebound in capital expenditure, says Bathgate.

"We're starting to buy companies that will benefit when confidence picks up enough for companies to invest more,' he says.

QE seems likely to continue into the early months of 2014 as the Fed waits for stronger recovery signals from the US economy. But markets' reactions show that investors would be smart to position themselves for the day QE finally comes to an end.


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