AllianceBernstein manager tells investors to be 'vigilant' ahead of Fed moves

AB's senior portfolio manager for fixed income investments, Jeremy Cunningham, said on Thursday that cutbacks in market-making by investment banks, coupled with underpriced risk in some credit classes, would lead to liquidity crunches as the US began lifting interest rates.

As yields rise, prices drop, leaving investors with book losses on their holdings. If finding buyers to draw a line under those losses proves difficult, the prices drop further.

Mr Cunningham said this could be especially true of non-investment-grade corporate issuance – known as junk bonds – in the US and Europe.

"Some investors are reaching down into that CCC bucket and below," he said.

"Our view is that you're not getting compensated for that risk that you're taking.

"CCC-rated bonds have performed well over the last few years, but if you're talking about scary places that's one of them."

His comments, during a visit to Australia to meet clients, echo those of a growing band of fixed-income experts, who warn that years of monetary easing has pumped up prices in a range of asset classes.

Investment veteran and former Federal Reserve economist Ed Yardeni, who now runs a closely watched US research firm, this week said quantitative easing in the US, UK, Japan and Europe had led to "insanity" trading in negative-yield bonds and overvalued shares.

Franklin Templeton bond guru Michael Hasenstab also warned, on a recent visit to Australia, that any spike in US inflation would force the Fed to speed up its tightening cycle, driving government bond prices suddenly lower.

This could force huge writedowns on portfolio values at pension funds and other larger holders of bonds, he said.

Mr Cunningham agreed investors should be "vigilant" against such a scenario emerging.

However, he expects inflation to only gradually move higher "as the US economy gathers momentum and, importantly, the labor markets continue to strengthen".

Recent volatility, in currency markets in particular, reflects changing bets on when the Fed will begin its tightening cycle after nine years of monetary easing. With recent economic data proving patchy, some who once saw a June start to interest rate increases now expect it in September or later.

Mr Cunningham said whenever the first rate hike came, there would be ructions in global asset markets as investors piled into US assets. However, he didn't expect to see the massive capital flight of the so-called "taper tantrum" of May 2013, when the Fed started to outline its plans for winding down its QE program.

"No matter how much the Fed prepares us for tightening, there will be a reaction," he said.

"The key is that the reaction will be a lot more muted than if the taper tantrum hadn't happened."

He said current tensions in asset markets had left them more vulnerable to other types of shocks, such as intensified conflict in the Middle East, or financial or political meltdown in Greece.

Mr Cunningham said these tensions had been exacerbated by the widespread reduction of market-making activities by investment houses unwilling to set aside capital against proprietary trading.

A range of financial market experts, including Guy Debelle from the Reserve Bank of Australia, and the Bank for International Settlements, have recently cautioned that many investors are underestimating this risk.

Mr Cunningham said AllianceBernstein had expanded trading teams specifically to spot potential liquidity traps when analysing the risk of buying certain bonds.

"Five or six years ago we had 10 traders; now we've got 20," he said.

"And the reason for that is not that there's more to do – it's just harder to do it."

He said AB investment teams now incorporated potential liquidity problems into their broader analysis of credit risk.

"Wall Street doesn't want to hold bonds – there's much less market-making," he said. "You almost have to provide your own liquidity in this market."