Once upon a time, you could manage bonds simply by referring to market indices. But historically low interest rates have changed the landscape. The methods that worked yesterday have been seriously undermined today, making it even more important to go back to this asset class's basic principles.

Back to basics

“It’s hard to beat a good old theory.” To paraphrase Robert Cobbaut, my former financial theory tutor, all bond managers should adopt this dictum. Whereas an equity manager can draw largely on “convictions”, it is maths that rules where bonds are concerned! Managing fixed-income securities obviously involves the notion of interest rate: for the borrower, it represents the cost of finance; for the lender, it is remuneration for the capital locked up; and for the central banker, it is the ultimate tool to manage the economy. At least, that was the case before the collapse of Lehman Brothers.

Times have changed!

But times have changed since then: by making cash available with their exceptional – but nonetheless long-running – quantitative easing policies, central banks have pushed interest rates down to record lows, creating a real ‘liquidity trap’. According to this Keynesian concept, the remuneration of bonds is so low that people prefer holding their cash rather than investing it. The ECB’s deposit facility rate has now been below zero for over four years.

This is something of a Copernican Revolution for the bond markets, a paradigm shift whereby the borrower of last resort is remunerated by the lenders! In the last three decades, yields have been slowly eroded in the leading developed economies: the yield on Germany’s 10-year sovereign bond, for example, has slumped from around 9.11% to 0.32%.

Jean-Philippe Donge, Head of Fixed Income, Banque de Luxembourg Investments

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