Roberts, investment director atStandard Life Investmentsin Edinburgh, manages £500 million in global government bonds against theJ.P. MorganGlobal Government Bond indices. He has been at Standard Life for 20 years.
What part of the curve do you focus on?
The bulk of our holdings are in the five- to 10-year area. The 10- to 30-year part of the curve has tightened already in Europe on the back of asset-liability matching by pension funds. We suspect the recent 10-15 point price move since the beginning of October--which is staggering absolute performance--is in part due to the involvement of arbitrage hedge funds. We believe that part of the curve is vulnerable to some correction in the near future.
In the U.S., the squeeze at the long end relative to the 10-years is even greater. In part this has been a reaction to mooted legislation to tighten up pension fund management to more closely match liabilities. This may, or may not, come to pass--but would surely be met by a resumption of 30-year government bond issuance. We're not planning to extend duration in either the U.S. or Europe in the near term.
Where are you focusing your government bond investments?
Europe and Japan present the best opportunities from the point of view of valuation and inflation outlook. Both areas have lower inflationary pressures than the U.S. and are less likely to see interest rate hikes. That said, if the recent rumors out of Japan are correct, that would be very depressing. You would hope the Bank of Japan would wait to get some inflation back into the system before tightening and keep interest rate hikes on hold until the economy is up and running, but it looks like they're intent on exiting their "zero interest rate policy" at the earliest opportunity. This could condemn the economy to further stagnation.
What is your view of government bonds in the U.S.?
The real yield in the U.S. is about 1.5%, which is pretty skinny, even compared to yields in the 1960s when inflation was similarly low. So from a value basis, we're not too keen on the U.S. and are below benchmark weight in U.S. Treasuries.
What would make you increase your weighting in the U.S.?
Our weighting in the U.S. is already heavier than warranted on a real yield basis. At the moment, you could say the economy is doing well, chugging along at 3.5-4% growth. But this growth is not resulting in a fundamental deterioration in inflation pressures. As long as this situation persists, there will be a question about the appropriate inflation rate with which to deflate bond yields. If inflation were to average 2%, rather than the assumed 2.5%, then the anticipated rise in yields would be less than presently expected.
Where do your views differ most from consensus?
We differ most in our views on the U.K. The consensus view is that U.K. interest rates are on hold, but we believe that if labor market trends continue to develop as they have been, interest rates could be increased to 5.25-5.5% by the end of year. The labor market continues to be tight, with surveys revealing skill shortages, vacancies and recruitment intentions at high levels. Average earnings have been rising inexorably over the past year and if we see average earning growth up to 5% in the next four to five months, there would be an increased probability of a rate rise from the Bank of England.
What out-of-benchmark bets do you have on?
We hold some high-quality corporate bonds in our government bond funds. As long as monetary policy is tightening, there is an argument to hold corporates, even though spreads on corporates have tightened significantly. In Europe we also invest in Pfandbriefe [German covered bonds], which provide a yield pick-up.
Do you invest in other covered bonds-from Spain or the U.K., forexample?
No, we haven't done so to date. The Pfandbrief market is large, liquid and established, and has permitted the diversification we have desired. There is nothing to prevent our exposure to Spanish cedulas, but we are not actively considering it.
What is your view of inflation-linked products?
We were heavily invested in Treasury inflation-protected securities (TIPS) in 2003 and 2004. In 2003 they had stellar performance, in 2004 another strong year, but less so. We lightened our exposure when the long break-even went out to 320 basis points in the middle of last year with inflation fears at their height. Given that TIPS have come off about 50bps (they're trading around 270bps currently), they are certainly more attractive now. In Europe, given our view that inflation will be very muted, linked products are not our focus.