Broomer's Blog

From the category archives: Fixed Income

Fixed Income

Pedalling Harder Just as the Brakes are Being Applied

My brother-in-law is a cycling fanatic. I asked him the other day if there is a technical term to describe pedalling while the brakes are being applied. He thought about this for a moment, before suggesting 'stupidity'.

It is almost 10 years since the financial crisis and the long drawn out recovery finally appears to be on a self-sustaining path. Monetary policy is gradually being tightened in the US, emergency rate cuts are being reversed in the UK and the ECB is dialling down its QE programme. With US unemployment just hovering above 4%, many monetary hawks will be thinking this is not before time.

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Filling the Bath in the Dark

NAIRU is one of those nasty looking acronym beloved by economists. Typically, the concept works very well in theory but has an unfortunate tendency to breakdown as soon as you apply it in the real world. It kinda makes sense that if there is a sufficiently large pool of unused labour in the economy, wage inflation will remain under wraps. Only once that spare capacity is used up do workers have the power to claim higher wages which are in turn passed on in higher prices.

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Gilts Be Damned

BofA Merrill Lynch recently put out a note highlighting that interest rates have fallen to a 5,000 year low. Quite how they have computed this and precisely what the practical implications it has are not clear but I think the gist of their message is self evident.

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Gilt trackers: Getting Touchy Just At The Wrong Moment

Market cap based passive investment strategies are supported by theory and appear to function well in many equity markets. They also appear to work for fixed income markets but here their track records are shorter and not so well supported by logic. The market cap approach directs flows towards the largest borrowers who are not necessarily those best positioned to honour their obligations.

A further issue is that the technical aspects of the way bonds are priced can have profound implications for the risk characteristics of the indices. The impact of the secular fall in interest rates has impacted prices of longer dated gilts far more than those with a shorter time to maturity. Gilts are typically issued around the par price of 100. Today, there are two high coupon long dated gilt bonds which are priced at over 200. As a result, the weighting of these two issues in the index is approximately twice that of when they were originally issued. Falling bond yields pushes out the average duration of the index (ceteris paribus).

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Taking Tea with the Mad Hatter

Mad Hatter: Would you like a little more tea? 
Alice: Well, I haven't had any yet, so I can't very well take more. March Hare: Ah, you mean you can't very well take less. 
Mad Hatter: Yes. You can always take more than nothing.

Alice's Adventures in Wonderland, Lewis Carroll

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Taking the P

Arguably bond investors are more logical and technical in their approach than many equity investors. This reflects the mathematical disciplines required to analyse fixed income markets whereas the greater uncertainties prevalent in the equity space is in keeping with a slightly more artistic bent. This is reflected in the key valuation metrics used by the respective camps. 

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