Over the last few days and weeks, as the odds of a vote to leave in the referendum have moved from a remote possibility to somewhat less so, market participants have spent more and more time wondering about how they are positioned going into the vote, relative to their benchmark, their peer group, or their risk budget. The significant moves that we have seen in recent trading sessions show pretty clearly that many were not content with their positions or risks going into the vote, as evidenced by a pretty clear period of volatility and risk aversion with selling of credit risk and a rally in government bonds.
Only a couple of weeks ago, the credit markets were frantically fighting to get hold of reasonable quantities of the significant amount of new issuance we were seeing from investment grade companies. A few weeks later, issuance has ceased and sellers of these much sought after bonds seem to be outnumbering buyers, given the back-up in credit spreads seen in recent sessions. The simple conclusion is that as the odds of Brexit rise, investors feel the need to reduce risk and are selling corporate bonds.
Playing devil’s advocate, let’s imagine that a portfolio manager has sold credit risk and raised cash ahead of next week’s vote. The portfolio manager is now feeling very satisfied at this moment in time as risk aversion has increased, resulting in a widening of credit spreads. However, the vote outcome is binary: either Britain votes to leave, or to remain. If the vote is to remain, then we can reasonably expect a significant retracement of the spread widening we have seen since fears of a leave vote rose.
If this proves correct then our imaginary portfolio manager is under-invested in credit and the credit risk that he or she sold will now need to be bought back, potentially at more expensive levels. Even if spreads did not rally in the event of a leave vote, then to replace the bonds that were sold, the portfolio manager will have to pay the prevailing bid-offer spread.
In other words, those selling credit risk now are predicting a vote to leave. This decision will benefit a bond portfolio as spreads rise, or as the leave probability increases, or if the leave vote were to occur (at least for a period of time, however long or short). But it does not work in the event of a vote to remain, and incurs costs on the bond portfolio.
Now let’s think about what to do with our duration positioning going into the vote. This, in my opinion, is an even harder call to make than with credit. Which way will gilt yields move in the event of a leave vote? On the one hand, the period of economic uncertainty that would result could see growth and inflation fall, which would argue clearly in favour of further falls in government bond yields. On the other, international investors currently own more than a third of the gilt market. What if these investors decide they no longer want to own sterling, or to own the same amount of sterling? Whilst my hunch is that the knee-jerk immediate response to Brexit would be for sterling to weaken and for gilt yields to rally further, how long would these moves last? Could we end the day with higher gilt yields and no change in the pound? Either way, the direction of travel of gilt yields is highly uncertain to me, which makes hedging or positioning duration for the referendum a very tricky call.
In my opinion, owning short dated breakevens is the most prudent way to go into the vote from the perspective of duration positioning. Firstly, if you believe that the currency is likely to weaken then you should own exposure to inflation linked bonds that will, especially at the front end, see higher inflation expectations from import inflation. This will support index linked valuations relative to nominal bonds. In other words, front end breakevens are likely to rise if sterling weakens. Secondly, putting the currency to one side for a moment, if yields rise (either on a leave vote as foreign sellers of gilts emerge or on a remain as risk appetite recovers and rate hikes are brought forward), then one would typically expect breakevens to rise. In this scenario, index linked bonds also outperform nominal bonds.
If yields fall on the other hand, a scenario most likely to happen in the event of a vote to leave due to risk aversion, then whilst typically breakevens fall, and so index linked bonds are underperforming nominal ones, at least owning breakevens means having a pretty decent link to nominal yields. It is difficult to create a scenario in which nominal yields rally strongly following a leave vote and index linked bonds fall in price (this scenario would be one in which inflation fears aggressively collapse, so it is not impossible, but it is unlikely).
So I believe that given the binary nature of the result, in which we are either in or out (what odds on 50:50, and what happens then?), the best way to be positioned in terms of duration ahead of the vote, outcome and aftermath is to own short-dated inflation linked bonds. It is not binary, as whilst owning breakevens means you are positioned for higher inflation, if breakevens fall following the vote and nominal yields fall, you are still linked to nominal yields and are likely to see the price of your bonds rise.
If the currency weakens after the election result, then import price inflation will lead to rising inflation expectations. And if the currency doesn’t weaken following the result, it has still been on a downward trajectory since last November which is yet to feed through into RPI, and the ugly current account deficit suggests on a medium term, fundamental basis, that there is more weakness ahead for sterling.
Finally, there are a number of reasons to choose front end index linked bonds. Firstly, front end breakevens are the cheapest on the curve. Secondly, the front end of the index linked curve is most likely to reflect inflation surprises and outcomes (such as oil base effects, sterling weakness, wage growth in the bonds’ prices); and lastly, because with gilt yields at all-time lows, it is prudent to keep interest rate risk at a relatively low level at this juncture.