(Bloomberg) -- Not everyone shares Bill Gross's conviction the bond bear market has started.
His former colleagues at Pimco are tiptoeing back toward securities most exposed to interest-rate risk, even as the psychologically key 3 percent threshold looms large for 10-year Treasury yields. And they're not alone -- Nomura Asset Management is also rekindling duration bets.
These money managers are calling into question the narrative that sees inflation roaring back with growth, and taking bond yields higher with them. For guys like billionaire fund manager Gross, a bond bear market was confirmed by 10-year yields above 2.5 percent in January. But even with a deluge of supply on the way and a more hawkish Federal Reserve, Pimco and co. think the selloff will not accelerate.
“We're starting to get to a level where it's interesting and we could cover our underweight in duration,” said Pacific Investment Management Co.'s Geraldine Sundstrom, London-based managing director and portfolio manager at the $1.75 trillion-fund firm. “We do not think inflation will rise rapidly.”
Instead, they see a more tempered pick-up in prices that will remain near the Federal Reserve's target of 2 percent and keep yields in check.
Gorging on Duration
Duration was a risk investors gorged on as zero-rate monetary policy turned yields on trillions of dollars of bonds negative. It's a measure of the sensitivity of a bond's price to a change in interest rates -- securities with longer duration typically gain more when rates drop, but suffer stiffer losses when they climb.
Richard Hodges at Nomura AM successfully hedged the bond selloff with downside exposure to government bonds since last November, through options contracts. He has now started to lengthen his fund's average duration in recent weeks after cutting it to zero a month ago.
“My duration was negative all through December and January, now it's positive,” he said. “Yields rose very quickly to meet our targets when the market rapidly began to discount more rate rises in line with the guidance that the Federal Reserve has continued to give us.”
Tricky Gamble
Effective duration remains near a record seven years, based on the BofA Merrill Lynch Global Broad Market Index, implying a price decline of about 7 percent for every percentage point increase in average yields. But as the world emerges from the depths of a decade of ultra-easy policies, gauging how dangerous rate risk is based on duration is a tricky gamble.
Central banks are curtailing stimulus, with the Fed also trimming its mammoth crisis-era debt holdings as it embarks on a steady path of rate increases. The European Central Bank halved its bond-buying program this year, leaving it open as to whether purchases will continue after the targeted end in September.
Still, analysts are asking whether investors got too bearish on duration as global bonds were engulfed in the selloff. The Treasury 10-year yield fell three basis points to 2.84 percent on Monday before Federal Reserve Chairman Jerome Powell addresses Congress this week. The benchmark reached 2.95 percent last week.
Closing Shorts
BNP Paribas SA strategists closed out their short-duration recommendation on Treasuries last week. They said bearish bets are less likely to pay off as market-implied forwards hover close to their forecasts, though they are sticking to their call to underweight duration in Europe.
The bond selloff has made “risk/reward of short duration positions less attractive,” London-based Laurence Mutkin wrote in a Feb. 22 note to clients. “We now expect U.S. and German 10-year yields to rise to 3.25 percent and 1.5 percent respectively by the end of 2018.”
Old Mutual Global Investors is considering following a similar path. Portfolio Manager Nicholas Wall said the firm has been debating whether to reduce the size of its short duration position. “We have been short duration for a long time now. We're not adding to them and actually are tempted to cover some of that short position now,” he said.
For Sundstrom at Pimco, the entry point is the 10-year Treasury yield at 3 percent. She doesn't see yields climbing much higher after they attain the closely-watched watershed.
“We're still very much in the new neutral where rates will be lower than in the previous cycle and inflation still unlikely to go up dramatically much beyond the Fed 2 percent target,” Sundstrom said. “Around 3 percent is the level we might consider buying.”
--With assistance from Charlotte Ryan
To contact the reporters on this story: Anooja Debnath in London at adebnath@bloomberg.net, Cecile Gutscher in London at cgutscher@bloomberg.net.
To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Samuel Potter, Todd White
©2018 Bloomberg L.P.
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