Are we in a bond bubble?
12 November 2019
By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy
In an era of depressed or negative returns, high leverage and thin liquidity levels, we believe that bond selection will be key in 2020, especially in the high yield sector. While performance is likely to be mixed in bond markets, we prefer investment grade and emerging market bonds.
Central bank accommodation puts a cap on yields in 2020
Yields on the equivalent of $17bn worth of outstanding bonds were negative in August 2019 (see chart). The fear that liquidity may need to be re-invested at lower or negative yields is one of the main reasons why institutional investors fix coupons with longer maturities even as bond yields reach sub-zero levels. As long as the threat of further policy rate cuts dominates, this trend is likely to persist in 2020.
Real yield should be the benchmark
The benchmark for wealth preservation should be the real yield (nominal yield adjusted for inflation) rather than the nominal yield. While a high nominal yield may look attractive on paper, it may be eroded by high inflation, as seen in 1980 when US 10-year nominal yields hit 13%, while inflation was at similar levels resulting in real yield of close to zero. Since 1980 the real yield has gradually declined on the back of a higher savings rate in emerging markets and a structural higher demand for safe bonds globally.
Global investor preference drives the market
We believe that the longer end of the rate curve will be capped for three reasons:
- Investor preference to hold longer dated bonds to mitigate the risk of re-investing at even lower rates in the near future. This preference intensifies the closer yields are to zero (last-chance purchase)
- Increased awareness of “tail risk” (since the credit crisis in 2008) and the subsequent desire to hedge against this risk
- Expectation that central banks will accommodate through quantitative easing when needed.
Rates volatility likely to increase
Although we believe that the trend of lower yields for longer won’t end in 2020, we see several factors which potentially could trigger temporary rate spikes in the near future: a constructive outcome from the US-China trade war negotiations, a positive Brexit outcome and positive economic or inflation surprise. We would see such spikes as an opportunity to enter increase duration.
Corporates leverage at elevated levels
Half of the US and European investment grade bond market is now rated BBB, while 13% is represented by the lower quality of BBB-rated bonds (BBB-/Baa3). Meanwhile, net debt in relation to operating earnings stands at 2.3 times, which compares with 1.5 times in 2001. At this point, higher leverage does not seem to be a concern, given low borrowing costs and stable earnings. Interest coverage (the amount available to serve interest rate costs) of 10% appears a comfortable level.
Fallen angel volume at historic lows
We have highlighted in our previous “Market Perspectives” publications that historically, the risk of defaults, even in severe adverse scenarios as seen in the 2008 credit crisis, was contained in the investment grade segment. But what about the downgrade risk? While larger companies, like GE or AB Inbev for example, have been downgraded to BBB, most of the predominantly large issuers used levers like asset sales, scaling back dividend payments or optimising working capital to keep the investment grade rating.
Rating agency Moody‘s expects “fallen angel” volume (that from issuers downgraded to high yield status) to rise to $50bn in 2020 in the base case scenario, while the amount could rise to $164bn, in a recessionary scenario. Still, a relatively low number, considering that BBB-rated bonds now amount to $2tn, more than double the $764bn seen in 2007.
The above reflects that downgrade cycles are not highly correlated to economic cycles but are more linked to company or sector-specific trends. As much as significant downgrades due to lower growth seem unlikely in our view, we think that the key to success in 2020 will be selection, while avoiding the most cyclical and leveraged companies within BBB space. Note that leverage in the BBB segment varies substantially: while the 25th percentile leverage ratio averages 1.6 times, the average ratio for the 75th percentile averages 3.6 times.
High yield bonds: Default rates at low levels, but cracks are appearing
Even if the European or US economy avoids recession, high yield issuers will be most exposed when growth starts to deteriorate. In Europe, for example, default rates are the lowest observed since 2008 at 1.1%. But trends are deteriorating beneath the surface: leveraged loans trading at distressed levels have doubled from 2% to 4% compared to 2018, while the low level of investor protection in bond documentation is another risk factor.
Only a little “BBit” high yield, please
Buying BB-rated bonds, the highest quality within high yield, was the favourite trade in 2019. This “tourism” flow led to the situation where the high yield market has performed well in a period while the lowest rating bucket, CCC, performed poorly. Such performance differentials are uncommon historically. They demonstrate that inflows are not a result of increased investor confidence in risky assets but a result of higher demand for yielding bonds in a world where yields are depressed. BB-rated bonds are expensive.
The spread differential between BBB and BB-rated bonds reached a two-decade low of 66 basis points while 15% of the overall high yield market trades inside the 80th percentile of BBB at this point. We feel that the vulnerability, combined with overcrowding, makes BB-rated bonds and the high yield market in general unattractive. We only see selective opportunities in 2020.
Emerging market (EM) bonds still offer attractive carry
While EM bonds should receive more support from lower rates globally, we believe that the diversity, combined with still constructive growth prospects, makes EM hard currency bonds an attractive asset class. While lower growth will be a challenge for most EM countries in 2020 we think some countries will cope with lower growth better (Brazil, India, Russia) than others (Turkey, Argentina). We think EM bonds will still offer attractive carry for investors and the should focus on countries with stable governments that are willing and able to implement necessary reforms in order to navigate through an environment of lower growth.
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