Fixed income outlook

05 April 2019

A persistently hawkish Federal Reserve has led to significant volatility in the major segments in the bond market in 2018. With the Federal Reserve indicating that rates are likely to be held this year, we think that stable returns are more likely to be achieved.

After a very volatile year in 2018, investors looking for stable returns may ask if they will face a similar rollercoaster ride this year. Given that the phase of normalisation of the monetary policy has been halted until further notice, we believe pressure of a significant rate sell off has eased, which creates opportunities to achieve stable returns.

Rates and government bonds

After the Federal Reserve (Fed) has increased rates, nine consecutive times accumulating 225bps, over the hiking period, Governor Jerome Powell recently indicated that the Fed Committee (FOMC) will likely leave policy rates at current levels this year. The future hike path, as projected by the median of the committee member’s expectations, has been lowered by 50 bps over the next two year horizon.

In the last policy meeting the outlook for growth and inflation has been revised downwards. In the same time, the FOMC notably changed its tone, compared to previous communications, indicating a more “patient” approach, according to the policy. This leaves room for a more sustainable pick-up in inflation.

Given the change in tone and the revised growth forecast, it is hard to see any rate hike for the time being. Market pricing goes even further: Fed fund futures imply a rate cut this year while the US interest rate curve has started to invert with the three months US bond yields trading higher than the 10 year yield.

This pricing seems very pessimistic. The US economy is far away from contraction and the very healthy US job market leaves the possibility for sudden inflationary surprises. Only a small positive surprise is required, for rates to re-price again.

We would prefer an overall neutral to slighter shorter duration in bond portfolios. Given the US rate curve inversion in particular at the 4 to 5 year tenor range, a strategy focusing on the two year and 7 to 8 year part of the curve seems a sensible way to achieve the neutral duration (see chart).

While investors may consider longer duration as too risky, we would highlight that longer dated bonds provide portfolio insurance should rates trend even lower from here.

Chart of US dollar swaps (30/360) curve

UK gilt and European bond markets continue to trade at depressed yield levels, leaving investors with negative real rates, while exposing them to sudden rate sell-offs as seen back in 2015 with German bunds. In its March meeting, the European Central Bank (ECB) pushed the expectation for a first rate hike to Q4 2020 pointing to risks from world trade, slowing growth in Germany and political risk from Italy. Given the slower growth dynamic and expectations, negative rates will persist for quite some time, as suggested by market implied forward rates.

In the UK, Bank of England (BoE) Chairman Mark Carney was not able to build that important rate cushion. Rising Brexit uncertainty forced the bank to lower growth and inflation forecasts most recently, while the policy rate had to be left unchanged at low levels. Although Carney uses excess demand as an excuse to keep rate hikes on the agenda, we believe this seems premature at this stage. Rate hikes are unlikely in the foreseeable future.

Investment grade bonds

Spreads (the difference in yield over an equivalent government bonds) of investment grade bonds as well as high yield and emerging markets have tightened significantly this year following the sell-off in December 2019.

US investment grade bonds spreads are roughly 30 bps away from levels seen in 2008 prior to the credit crisis.

Investment grade bonds in the US and Europe are trading close to the tightest spreads seen in 2018. In the case of US investment grade bonds, spreads are roughly 30 bps. away from levels seen in 2008 prior to the credit crisis. Given the already tight spread levels, the room for further compression seems limited.

The credit cycle is getting older and credit risk has increased over the last 10 years. The rise in leverage among non-financial issuers has led to a substantial increase in the portion of BBB rated bonds within the investment grade sector. For instance, US ‘BBB’ rated bonds make up 52% of the investment grade market compared to 40% in 2011. Simply based on the higher proportion, it can be argued that the risk of investment grade bond issuers getting downgraded to high yield or ‘junk’ status has increased.

With lower growth expectation on both sides of the Atlantic, companies with weak credit profiles will be even more exposed to eventual downgrades. That said, economic data is still robust and specifically larger issuers have improved their funding costs during an extended period of low interest rates.

The majority of the BBB-rated issuers come from defensive sectors like utilities that naturally have relatively high borrowing levels but, at the same time, are less exposed to economic downturns. Furthermore, large companies have various levers available in order to manage and maintain their BBB rating.

At this point we see limited risk of a large downgrade cycle. European investment grade bonds yield substantially higher than comparable German bunds offering relative value while yields of US investment grade corporate bonds offer attractive absolute yields.

US and European high yield bonds

The Bloomberg Barclays US High Yield Index and its Pan-European counterpart have performed close to 7% and 5% respectively this year. Is spread volatility likely to return in 2019? We look at default rates, as well as upcoming maturities and would argue that the risk at this moment should be fairly limited.

Global speculative default rates are at historic lows at 2.2% (European default rates being significantly lower) and Moody’s expect that this rate to fall further over the course of this year. Meanwhile, the upcoming amount of debt maturity seems manageable partly due to most issuers having extended the debt maturity profile in the period of low interest rates.

Still, investors are likely to get more selective after the broad market rally. It is worth noting that US traditional retailers see increasing competitive challenges, while in Europe the highly leveraged telecom, media and technology sector is set to continue to struggle.

Emerging market bonds

Bloomberg Barclays EM USD aggregate

This asset class can be subject to sharp changes in sentiment. On the one hand, the asset class underperforms during phases of global contraction, which usually is accompanied by safe-haven flows. On the other hand, investors tend to exit the emerging market (EM) ‘carry’ trade (investing in a comparatively higher yielding bond segment), as soon as US rates pick up, which usually can be seen during an economic recovery. During which part of the economic cycle do emerging market bonds perform? We think this is the case in the current late stage of the cycle.

Historically EM capital inflows were highly correlated with the size of central bank balance sheets. The balance sheet reduction induced by the tapering of central bank bond purchasing programme, most notably by the Fed, has led to large EM outflows until recently.

With the end of that Fed tapering in sight and the shift to a more accommodative monetary policy in the US, we see further room for a recovery of EM bonds. At around 5.3%, the average yield of US dollar denominated EM bonds (taken from the Bloomberg Barclays USD EM Aggregate hard currency bond index) looks reasonable on an absolute and relative basis (see chart). Despite the recent spread tightening, the USD EM Aggregate option adjusted spread (OAS) at around 290 bps trades well above the comparable US high yield BB bond complex OAS at 236 bps in comparison..

This difference of 54 bps compares with the average spread difference in the last six years of around 20 bps only. Apart from the growth risk and fiscal imbalances in some of the EM countries, the political risk stays elevated (Brazil, Mexico, China). That said, a positive outcome in trade deal negotiations is likely to improve the sentiment towards EM bonds.


Market Perspectives April 2019

Find out our latest key investment themes. And with volatility set to stay elevated in 2019, can markets head higher still this year?


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