Tapering, Portfolio Positioning and the way forward

Global financial markets were eagerly awaiting the 18 September 2013 Federal Open Market Committee (“FOMC”) meeting as speculation was rife that the US Federal Reserve will commence ‘tapering’ the $85bn worth of monthly bond purchases. This ultimately means that the US Federal Reserve will begin to pump less money into the US economy on a monthly basis. Some surveys showed that up to two thirds of the economists polled expected the US Federal Reserve to announce a reduction of $10bn-$15bn in the bond-buying program. Such speculation had indeed got market analysts re-thinking their strategies and portfolio managers re-positioning their portfolios as the potential withdrawal of liquidity could result in a marked change in interest rate expectations.

However, the US Federal Reserve caught the market by surprise as Chairman Ben Bernanke highlighted that incoming data on the perceived US economic recovery was still not strong enough to warrant the withdrawal of stimulus from the markets. Furthermore, the central bank lowered US growth forecasts to 2.2% from the previous 2.5% for 2013 and to 3% from 3.3% for 2014. As a result, government bonds expected to remain supported till year end and the sustainability of any economic recovery still in doubt, default rates are expected to remain relatively low and high yield issuers will continue to benefit from lower financing costs.

The absence of any Fed tapering must have delighted the ECB which has publicly indicated its preference for a more accommodative approach and for lower rates for a longer time to support the fragile economic recovery in the Eurozone. Some European countries still remain in a technical recession; the sovereign debt crisis still needs to be resolved as many countries still struggle to keep deficits under control, whilst the banking union is still in its infancy stages.

The Fed has made it clear that Quantitative Easing (QE) was never really intended to last forever. In fact, in previous testimonies, Bernanke stated that the continuation of the program was dependant on incoming economic numbers, namely GDP, unemployment and inflationary data. Bernanke stated on 22 May 2013; “If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings […] take a step down in our pace of purchases.” Following the lack of announcement of any tapering in the Fed’s September FOMC meeting, the market is aware that tapering is still very much on the cards and it will only be a matter of time before it begins. From the flurry of hints being thrown at investors, the markets seem to be well prepared for it, and when it happens, it will be yet another hurdle to surpass just like the many they have had to overcome in recent years.

Analysts argue that the exact starting point and the magnitude of tapering does not matter very much. The most important thing for an investor is the conviction that QE will end over the next three years or so and will therefore aim to position his/her investment portfolio in line with these expectations. Effectively, the end of QE should not be viewed as market negative; it merely implies that the economy is passing through a normalisation process. Economic normalisation is usually associated with GDP growth rates of 2.50-3.50%, inflation well above 2% and government bond yields in excess of 4.50% on a historic basis.

We have been warned. QE will come to an end, maybe not as early as mid-2014 as originally targeted by the Fed. Termination will come either due to economic normalisation as explained above or as a result of asset mispricing/distortions (brought about by excess market liquidity) which situation will leave the Fed with no option but to terminate QE in advance. Whatever the scenario, it is of paramount importance for investors to position themselves adequately and cushion their bond portfolios for any expected volatility and possible re-pricing brought about by such changing circumstances. In a scenario where interest rates are expected to increase, the long end of the yield curve (government and corporate bonds) should be avoided as the longer dated bonds are most vulnerable to a market correction.

Since the financial crisis broke out three years ago, default rates have remained surprisingly low, and are expected to remain anchored at low levels as economic activity picks up and corporate balance sheets improve. It is then unavoidable for an investment portfolio to be exposed to market risk, making the process of security selection the fulcrum of any investment decision. Having a bond portfolio full of winners is close to impossible, but keeping a well-diversified portfolio of good credits will ensure that investors are commensurately rewarded.

What is certain is that the flurry of non-conventional measures utilised by the major central banks, mainly in the form of QE and Long-Term Refinancing Operations (LTRO), have supported the bond markets in an unprecedented way. Long-dated bonds rallied the most as the global search for yield spurred investors to deploy their cash hoard by lengthening their maturity profiles. However, with talks of possibility of withdrawing market liquidity, recent market movements have shown how extreme bond sell-offs could be. And this is only the beginning. The signals are there, the conviction that it is only a matter of time when QE is tapered is also apparent. Investors should take stock of the recent FOMC meeting and interpret it as being the opportune moment to begin to shorten the maturity profiles of their bond portfolios in an attempt to preserve capital and limit un-necessary portfolio fluctuations. When interest rates begin to rise, and they do tend to have a habit of rising fast, it could be too late.

In view of this, High Yield bonds as an asset class offer a decent buffer against higher interest rates. For credit investors, the High Yield market is likely to continue to offer good diversification in a rising interest rate scenario as its performance has historically been negatively correlated with those of Bunds and Treasuries.

Calamatta Cuschieri & Co Ltd, Company registration number C13729 (‘CC’) is licensed to conduct investment services in Malta by the Malta Financial Services Authority. This article is prepared for information purposes only and does not constitute investment advice or marketing communication. It does not constitute an offer or invitation to any person to buy or sell any investment or to enter into any business relationship with CC. This article is based on information obtained from reliable sources but which have not been independently verified. CC is under no obligation to update the information in this article. No person should act upon any recommendation in this document without first obtaining professional investment advice. CC does not accept liability for any actions, proceedings, costs, demands, expenses, loss or damage arising from the use of all or part of this article.

The information in this article is valid as at 27 September 2013.