The 2019 bond rally has reached epic proportions this summer. A hearty pack of skeptical investors is betting it is way overdone.
Sentiment in debt markets has rarely been more euphoric. Yields on German government bonds have slumped to all-time lows, pushing prices higher and driving the stock of global negative-yielding debt to $15 trillion. Yields on 10-year U.S. Treasurys this week fell below two-year yields for the first time since 2007, a pattern known as inversion that many investors view as a harbinger of economic recession.
The most acute stage of the rally has come since the Federal Reserve cut interest rates in July for the first time in more than a decade. Investors often interpret a Fed rate cut and fears of economic slowdown as signals to buy bonds because they often presage a multiyear cycle in which interest rates decline, boosting the prices of existing debt securities.
But these traders and fund managers don’t think it will play out that way. Instead, they insist the global economy remains essentially healthy. They see bond markets as overly pessimistic and are making bets against debt securities that are overbought—just in case yields rise in the months ahead as the market reassesses the global growth story.
One obvious target for these contrarians is debt issued by eurozone sovereigns, much of which now offers a negative return, meaning investors are paying governments to take their money.
“You’re either going to make very poor returns from government bonds going forward or you’re going to make extremely poor returns,” said Tristan Hanson, a fund manager at M&G Investments, who recommends investors buy equities and avoid bonds issued by Group of Seven governments.
Some 13% of the £117.27 million ($141.71 million) that M&G Episode Macro Fund is placed in a short bet against negative-yielding German government debt, Mr. Hanson said. The rationale is that “there is a limit on how far those yields can go even in an adverse economic scenario,” given the European Central Bank has set negative benchmark rates, he said.
Other investors are now paring back their bets on a further drop in yields in the U.S. They reason that many of the risks weighing on the global economy—including trade tensions and uncertainty over Brexit—could unwind rapidly, sending yields higher.
Xavier Baraton, global chief investment officer for fixed income at HSBC Global Asset Management, has been buying Treasurys that mature in two to 10 years. He is now betting against comparable bonds that mature in 15 to 30 years as a form of “insurance” in case investors’ gloomy economic outlook is overdone.
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“The global economy—while not in perfect health—is stable and a global recession looks unlikely anytime soon,” he said. He contends that yields on longer-dated debt reflect the market’s long-term outlook on the economy rather than short-term monetary policy.
The yield on 10-year U.S. Treasurys has tumbled to 1.61% from 2.03% at the start of August, sending prices on the bonds soaring. The yield on U.S. 30-year debt has dipped below 2% for the first time, from 2.53%.
For now, the wagers that yields could rise in the coming months remain small, contrarian positions. Being long U.S. Treasurys was the “most crowded trade” in the Bank of America Merrill Lynch’s monthly survey of fund managers in July for the second month in a row. Crowded trades are ones that are so popular that any reversal of sentiment threatens to saddle recent buyers with significant losses.
Paul Brain, head of fixed income at Newton Investment Management, a BNY Mellon subsidiary, has been buying up 30-year U.S. and German government debt all year. But he also put on bets against the five-year debt in April and again in May. His plan was to short some part of the yield curve, to make the most of a dip between three and five years and a flattening of the curve.
“If we don’t get a recession, then the market has priced in too much,” said Mr. Brain. “We don’t want to bet everything on just that one belief.”
Bryan Carter, head of emerging-market fixed income at BNP Paribas Asset Management, has been buying up sovereign debt this year, taking large positions in Ukraine and some other lower-grade issuers. But he has recently taken a short position on eurodollar futures, which use the interest rate on dollar-denominated deposits held in European banks as a reference—a bet that would make money if the Fed delivers fewer rate cuts in the next year than markets expect.
Jeff Keen, a director and head of fixed income at Waverton Investment Management, has been buying put options on German government bonds, which gives him the right to sell the debt in future at a set price. It is, he says, a “contrarian bet that things are not quite as black and white as the market might think.”
The yield on 10-year German government bonds has dropped to minus 0.71% from 0.24% at the end of December.
“In a normal kind of environment, if we ever get back to that, bonds should provide a real return, which means yields should be above the policy target rate which is 2%,” Mr. Keen said.
—Patricia Minczeski contributed to this article.
Write to Avantika Chilkoti at Avantika.Chilkoti@wsj.com and Anna Isaac at firstname.lastname@example.org
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