The Bank of England has warned in the Financial Times 26/03/15, that current issues in Greece and China, “pose a significant risk to the UK’s financial system”. So what could go Pop ?
The Bank of England is worried about Liquidity Risk. This is about how easy it is to buy or sell certain assets and what happens if certain markets like bonds or fixed income seize up.
This follows an article from earlier in the week, “Global fund managers warn of Bond Bubble”, from the Financial Times 22/03/15, where ‘investment managers fear bond markets could seize up”.
Like any crisis we have been through, be it the credit bubble of 2008/09 or the tech bubble of 2001/03, the greatest risk comes from everyone holding too much of the same thing, and when everyone wants to exit at the same time, the crunch happens.
The article quotes Brad Crombie, head of Fixed Income at Aberdeen Asset Management, “this market could pop… there is more tension and anxiety over valuations than for a long while.”
It goes on to quote John Stopford, head of Multi Asset at Investec, “there could be a price dislocation and messy unwind.”
Translated, this means that the managers of corporate bond and fixed income funds are worried, because they know that when interest rates rise, the capital value of some of their holdings will fall, and so this will affect fund performance.
So just as the banks went pop in the credit crunch, bond managers are worried about ‘liquidity risk’ and that some parts of the bond market could go pop.
How can something lower risk become risky ?
It’s to do with the ultra-low interest rates we’ve had since 2008. But as we know this is not normal and at some point they will go back up again.
The problem though is that interest rates have to normalise from such a low level, where any small increase, is much bigger in percentage terms.
Traditionally, bond funds have been regarded as less risky than equities, but this conventional wisdom is being challenged. Could bonds now become risky, as interest rates rise ?
Why does this affect me now ?
Last week’s Federal Reserve meeting, leaves the door open to US interest rate rises later this year, which could bring on the ‘bond crunch’.
Many portfolio managers are holding very high allocations to bonds, which could be subject to high volatility when interest rates rise.
Retiree portfolios will typically have a large allocation to fixed income and corporate bonds, and so this causes problems in terms of managing risk.
Whilst bonds have worked well for the last six years, this could be about to change, and cause a great deal of stress in terms of volatility and risk.
What’s at stake and why ?
The USA has had falling interest rates since 2006, and so we have grown used to fixed income and corporate bond funds doing quite well.
But what used to be thought of as quite safe, could become a liability, and expose a portfolio to capital losses, as interest rates rise.
This is a huge problem for ‘model portfolio’s’ or computerised risk models, because they are not taking into account where we are, and what is actually going on.
I see a lot of managers still holding large amounts of corporate bonds because the model says so, or because the ‘conventional wisdom’ says so. But the last six years can hardly be described as conventional, and so does convention still work ?
Interest rates are rising from the artificially low levels we have had for six years, and the transition to so called normality poses more questions than answers.
Last week Ray Dalio, a person that world leaders consult for advice, and who manages $160 billion at Bridgewater Associates, issued a note warning about the effects of US interest rate rises.
We’ve always known that Quantitative Easing was a big experiment; it’s an even bigger experiment to get ourselves out of it; it changes what we are used to.
So what are fund managers doing about it ?
Well if you are in a corporate bond fund or a strategic bond fund, they are not doing very much because they have to do what it says on the tin… invest in bonds.
Therefore, for the first time since the crisis, it’s vital that you know what you’re invested in, because some managers will not take any action to change anything.
It comes down to how closely you know your investment manager, and how well they know you.
It’s about whether you are at a stage in life where you have reached critical mass, your life-time’s wealth, and whether you want to protect what you’ve achieved.
It’s simply managing risk, or not !
How do I stay on a ‘Peak’ for longer ?
We know that life is full ‘Peaks’ and ‘Troughs’, and that happiness in life is spending more time at the ‘Peaks’.
Well markets are no different, and so when you are at a ‘Peak’, you need to make sure you spend longer there, and so you need to protect what you’ve made, and prepare for any turbulence.
To do this you sometimes need to ‘adapt’.
Last week the Fed dropped the word ‘patience’ from its forward guidance leaving the door open to interest rate rises later in the year. In time, this will go down as a ‘defining moment’.
Good wealth management is all about recognizing these ‘defining moments’, being able to adapt, and protect the downside.
The above commentary is for general guidance purposes only and does not constitute financial advice. Please consult your usual advisers before taking or refraining from any action. The value of investments and income from them can fall as well as rise, and past performance is not a reliable indicator of the future.