What this bond investor is watching most closely into 2024

Fixed Income assets were the talk of financial markets last month when a change in tone from the US Federal Reserve sparked a historic rally in 2- and 10-year bond prices. These have pulled back since then but the bullish view on bonds has continued.

I recently asked Ardea Investment Management’s Gopi Karunakaran for his outlook, thoughts on portfolio positioning, and other insights gleaned from his two decades of experience investing in global fixed income markets.

What indicators do you watch most closely?

“Risk diversification, always,” is Karunakaran’s unequivocal response.

He emphasises a key difference between Ardea’s specialised investment approach and that of all other “conventional fixed income” lies in what his team ignores. Karunakaran explains that duration and credit are the two levers on which all conventional fixed income is based.

“The risk/return trade-off involves accumulating bonds to earn yield, in exchange for accepting duration and credit risks. The focus is largely on yield and getting directional market calls right,” Karunakaran says.

“We ignore all this, instead specialising in a third fixed income lever that generates returns from market inefficiencies – ‘pure relative value.’”

This high turnover relative value (RV) trading strategy uses highly liquid and investment-grade government bonds – typically rated triple-A or double-A – to profit from RV mis-pricing opportunities.

“These underlying market inefficiencies cause related securities with similar risk profiles to be priced inconsistently with one another. These trades combine into portfolios aiming to deliver low volatility returns that are independent of the level of yields, direction of rates, and broader market fluctuations,” Karunakaran says.

He singles out risk diversification as the key to doing this consistently over an extended period.

“We intentionally diversify risk across hundreds of small trades, with none being meaningful in isolation, but collectively they build up an attractive risk/return profile, while successfully navigating the inevitable ups and downs of financial markets,” Karunakaran says.

Last September, you said bond markets might have over-compensated for central banks’ policy response. Has this played out?

A little over 12 months ago, Karunakaran was asked whether bond markets had already priced in the actions of central banks to rein in inflation.

His response at the time was “Yes, to a huge extent, possibly even to too much of an extent.”

“You've seen inflation expectations coming down, to us, that's a signal that bond markets have run quite far ahead with this whole narrative that the rate hikes that are priced in will be enough.”

Reflecting on what has happened since then, Karunakaran notes the following:

• “The RBA and Fed were forced to hike rates a further 1.75% and 2.25% respectively.
• “The widely followed benchmark 10-year US Treasury yield rocketed a further 150 basis points higher to reach a multi-decade high of 5%
• “Back then, if you had invested in the popular long-duration US government bond ETF (NYSE: TLT), you would have lost a whopping 20% over the subsequent year to 30 September 2023.”

“So, yes, in hindsight we can see markets were premature in giving central banks credit for getting inflation under control,” he says.

What changes have you made to the portfolio since the US Fed’s September update?

Karunakaran notes the high turnover trading-oriented strategy his team follows means the portfolio changes daily. He also emphasises Ardea’s focus on identifying pricing inefficiencies rather than attempting to predict market direction: “Unlike conventional FI investors, we don’t react directly to macro events such as central bank decisions.”

Karunakaran refers to the often-cited analogy of “picking up pennies from a train track,” which is frequently used to demonstrate how a string of profits can be wiped out by a single event risk.

“The train, being analogous to a market-moving event, creates turmoil as it steams through financial markets, catalysing diverse reactions among FI market participants, for example, forced selling, profit taking, and hedging,” he says.

“The resulting buying and selling activity can cause temporary demand/supply imbalances, which in turn creates RV mispricing opportunities."

"Our portfolios profit from this via RV trades that isolate exposure only to the relative price movements between mispriced securities, rather than to broader market fluctuations,” Karunakaran says.

On the other side of these price movements – once the demand/supply imbalance resolves itself – “relative pricing consistency returns and we can exit the trades at a profit.”

“Returning to the analogy, we step in to pick up the pennies in the aftermath of the turmoil created by the train.”

What is your investment approach to duration?

Karunakaran emphasises that his team doesn’t take a view on duration – a measure of how long it takes for an investor to be repaid a bond's price by the bond's total cash flows. That’s because Ardea generates returns from relative value mispricing rather than predicting bond market moves.

“We don’t need to have a duration view, which is fortunate because it is extremely hard – perhaps impossible – to consistently get duration calls right because they are necessarily based on macro forecasts of inflation, economic growth and other variables,” Karunakaran says.

“The problem is that macro forecasting has a very poor historical track record, generally being no better than a random coin toss. Even worse, macro forecasts tend to be most wrong when they matter most, which is during macro regime shifts.”

As an example, he points to the period in late 2021 and early 2022, when the widespread calls of “transitory inflation” were proven incorrect.

“Expert forecasters grossly underestimated the magnitude and persistence of inflationary pressures, and by extension the extent of damage that duration exposure would do to fixed income portfolios,” Karunakaran says.

To illustrate this, he singles out quotes from two of the world’s biggest investing names:

• Warren Buffett: “For a piece of information to be desirable, it has to satisfy two criteria: it has to be important, and it has to be knowable.”
• Howard Marks: “We don’t base our investment decisions on macro forecasts. The reason for this is simple: to use Buffett’s terminology, we’re convinced the macro future isn’t knowable.”

Which fixed income assets do you favour currently?

As noted earlier, Ardea invests only in liquid, high-quality government bonds that are typically rated triple-A or double-A.

“Given we adopt a high turnover trading-oriented strategy, we constantly shift portfolio exposures across the large and diverse range of sub-segments that comprise global interest rate markets,” Karunakaran says.

“These shifts are driven by idiosyncratic bottom-up considerations, such as shifting to the next new RV trade opportunity, rather than top-down strategic views.”

He points to the following two important thematic shifts that are playing out in global interest rate markets currently:

• A new regime of structurally higher volatility for government bond/interest rate markets. “This means that for any level of bond yields, investors should now expect materially higher price volatility,” Karunakaran says.
• Material increases in the supply of government bonds, as governments issue more bonds to fund higher budget deficits, “at a time when the single biggest buyer (central banks) are explicitly reducing their purchases.”

What does this mean for investors? 

It’s still “highly uncertain” what the above points mean for bond yields from here and broader bond market performance.

“But it is clear this leads to higher bond price volatility and greater dispersion of pricing between similar bonds, which creates a fertile opportunity set for market-neutral RV trades,” Karunakaran says.

What’s the biggest thing you’re watching for into 2024?

“Government bond volatility,” says Karunakaran.

He explains that government bonds are in a new regime of volatility because:

• “Central banks have shifted from being volatility suppressors to volatility amplifiers,” and
• “Demand/supply dynamics in government bond markets are now more variable.”

Karunakaran notes some key contrasts between the new era and most of the post-GFC period, when central banks were able to suppress volatility because their “dual policy objectives of price and economic growth stability were aligned.”

“With inflation generally running below target, the actions required to stimulate inflation also supported economic growth. This meant it was easy for central banks to step in with policy support whenever financial markets wobbled,” he says.

And now?

Karunakaran believes central banks’ dual policy objectives conflict: “The actions required to suppress inflation risk tipping economies into recession.”

“Central banks, therefore, face a tenuous balancing act, which heightens macro uncertainty and hence makes them volatility amplifiers.”

At the same time, Karunakaran notes the increasing levels of bond issuance from governments – to fund deficits driven by the COVID-era fiscal stimulus.

“They are doing this just as central banks – formerly the largest buyer of government bonds – are winding back their bond purchases. The net effect is more variable demand/supply dynamics in government bond markets, which is a catalyst for bond price volatility.”

If you weren’t managing money, what else would you be doing?

“Reading,” says Karunakaran.

“For anyone with even a hint of intellectual curiosity, we live in an astonishing era of abundance. Our access to high-quality information and ideas about the world around us is astounding and if I had more time, I’d take full advantage of this.”

Learn more

Ardea Investment Management is a specialist fixed income investment manager with a focus on delivering consistent alpha to clients through an investment process supported by a highly intuitive risk system. For further information, please visit their website or fund profile below.

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Ardea Real Outcome Fund

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ActiveX Ardea Real Outcome Bond Fund (Managed Fund) (XARO)

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