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Time to be selective in fixed income

02 August 2019 , 13:13

3 minute read

By Michel Vernier, CFA, Head of Fixed Income Strategy

As we head deeper into the cycle and with ever higher levels of leverage, a diversified and selective approach to bond investing is key.

Central bank monetary policy has the power to move markets quickly and sharply. So it is little wonder that investors pay much attention to central banks. That said, it is fixed income investors that are at the sharp end, being directly affected by policy shifts for two reasons.

First, rate policy, and bond purchasing programmes, directly impacts rate-sensitive fixed income portfolios and determines how much can be earned for any new bond investment.

Second, rate policy indicates how confident central banks are about the outlook for the domestic, and global, economy. The less confident policymakers are about the outlook, the more willing they are to provide monetary support to the economy.

Rush to bonds

Major central banks are taking a more dovish tone, with the Federal Reserve (Fed) leading the way by cutting rates in its July meeting by 25 bps and halting its balance sheet reduction in August.

The move was not as dovish as markets had priced in, with chairman Jerome Powell denying that this was the start of an easing cycle and the front end of the curve selling off as a result. The dovish stance and monetary support from central banks has led to record flows into most parts of the bond market.

Only once inflation starts to retrace from current low levels towards the Fed’s longer term inflation target of 2%, will rates trend higher. At least for now this seems unlikely.

Buy-and-hold bond investors might not only focus on central bank “bail outs”, yield and spread, but most importantly assess how likely they are to get their capital back along with any promised coupon payments.

Dangers of excessive debt

In a period of macroeconomic consolidation, the most decisive factor is usually the level of leverage. Debt is a supporting factor for the economy as it allocates surplus cash efficiently to where it is required to invest in future growth. Excessive debt, on the other hand, can lead to inefficiencies and distress in the economy.

In a period of macroeconomic consolidation, the most decisive factor is usually the level of leverage.

Not all distress will eventually end up in a global credit crisis like in 2008. However, at a time of contracting growth, too much leverage can spill over and have negative impacts across sectors and regions. In recent years, good examples of excessive debt-induced distress include Argentina, Brazil, Greece, US high yield energy, UK retail or the Chinese property market.

Default risk

The impact of credit cycles on global growth and capital markets has long been debated by many; including the renowned economists Hyman Minsky, Barry Eichengreen or Irving Fisher.

Economic growth, default rates and the performance of fixed income assets are all interconnected. Rather than opening the debate over the credit cycle, we focus on fixed income investments.

Previous stressed periods have proved one point for successful buy-and-hold investors: being selective is the key to success. As much as most of the distress examples mentioned above have led to spill-over effects and increased volatility in other markets, they did not necessarily trigger a global wave of debt defaults. Even the 2008 credit crisis did not result in major defaults for holders of debt in non-financial investment grade corporate companies.

Previous stressed periods have proved one point for successful buy-and-hold investors: being selective is the key to success.

According to rating agency Moody’s, the default rate for Baa rates issuers did not surpass 1.5%. during the credit crisis. To put this into perspective, the default rate of US high yield issuers stood at 2.9% in May.

Leverage on the rise

Since the substantial contraction seen in 2008, the level of financial leverage globally has increased: the rise of corporate leverage, developed and emerging market government leverage, increase in loan market assets and flood of wealth management products seen in China help to demonstrate the point.

At times of distress, not every market segment should be considered as excessive or problematic necessarily. Bond investors should be conscious of this and be selective with investments.

Spotting the investment opportunities

In coming editions of “Market Perspectives” we will highlight where leverage has been built up and to what extent it may be a concern for fixed income investors.

Our key calls in the fixed income market are longer term rated bonds and USD-denominated emerging markets bonds. While not without risk, we believe that longer term BBB bonds and US dollar-denominated emerging markets debt offer a good risk reward in the current environment.

BBB long duration bonds offer significant higher spreads compared to sovereigns. Meanwhile, spreads are comparably safer in times of subdued economic growth compared to speculative grade bonds. Emerging markets bonds historically performed well in a late cycle, in sync with the commodity cycle and central bank accommodation. But as always, diversification and selection is key in all areas of the bond market.

We believe that longer term BBB bonds and US dollar-denominated emerging markets debt offer a good risk reward in the current environment.

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Market Perspectives August 2019

Find out our latest key investment themes. As expectations of more dovish central bank policy grow and early signs of a potential thaw in trade tensions, sentiment has turned for the better. However, with many geopolitical issues on the horizon and several financial markets close to record highs, is it time to de-risk portfolios?

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