A closer look at risks in the bond market

31 January 2020

6 minute read

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

Bond markets performed well in 2019. With the chance of higher volatility, higher default risk and possibility of rating downgrades, does value still exist in the asset class?

In hindsight 2019 was a “blue sky” scenario for bonds: the economy was not too hot and not too cold. Bond assets across various segments delivered double-digit returns. After last year’s rally, is there any value left in bond investments?

We believe that there is still value although admittedly returns are likely to be limited and selection even more so important. With yields and spreads alike at low levels, we take a closer look at the potential risks facing investors.

Risks for rates to sky rocket

The US 10-year Treasury yield rose to almost 2% early in January from 1.45% in September. Over the last ten years it seems rates have consolidated, with a large upward move within 12 months after the yield reached 1.5% (see chart). Will we see the same pattern again this time after the yield reached these lows in August 2019?

is the rate market due another correction

While the reason for bond market corrections always seem to be different (for instance, the US Federal Reserve’s (Fed) “taper tantrum” in 2013 or the US fiscal stimulus-induced correction in 2016) one common feature can be observed. The moves have been fed by extreme positioning around a strong consensus view.

Although a correction should not be ruled out in coming months, there does not seem enough reason to justify either a long-term trend change or a significant re-pricing in bonds. The US-China "phase one" trade deal has been absorbed by the market while US stimulus, even in the wake of the US elections, might be contained this time.

A pick-up in inflation, or inflation expectation, may be another reason for rates to trend higher. Under the current period of slowing growth, as indicated by lower manufacturing indicators for example, it is hard to believe that there is enough room for a significant change in recent trends.

Given that market implied inflation expectations seen in breakeven rates are comparatively low we see some upside surprise potential. Inflation surprise could be triggered by higher wage growth due to ultra-low unemployment rates or from a Fed running a looser strategy and accepting higher inflation. Inflation linked bonds therefore seem reasonably priced to hedge against that surprise potential.

Risk of 0 or negative yields

Will we see even further depressed yields in 2020 or a spill over to other markets, like the US or UK, that are “not supposed to offer negative yields”?

In Europe there is an increasing debate about the effective ness of negative yields and more concerns about the harm it creates (for instance, on bank profitability or diminishing savings). However, it seems unlikely that the European Central Bank (ECB) will change its policy for some time given the prospects of depressed inflation. European yields are likely to stay lower for longer.

Spillover effects

Negative rates have already had a spillover effect on US yields. The large interest rate differential between the two markets, which currently stands at approximately 1.7% for 5-year swap rates, drives flows into the US market which prevents yields drifting too much apart. By contrast with the ECB, the US built up a buffer and thus has scope to reduce rates. So even in a recessionary scenario negative yields in the US seem highly unlikely.

UK rates, on the other hand, seem more at risk of slipping into zero or negative territory. While Bank of England strategy is against a negative yield policy, the policy rate is only 0.75% away from zero and interest rate markets at times tend to push rates down below the policy rate, along the curve. Although we do not forecast significantly lower yields, the risk of it happening is higher than in the US and should not entirely be ruled out.

As long as rates are trading close to zero or below, medium duration higher quality bonds will enjoy higher demand in order to mitigate zero or negative rates globally.

Risk of defaults and downgrades

Recently the International Monetary Fund listed “rising corporate debt burdens” as a key vulnerability in the global financial system. According to the latest World Economic Reform report across G20 economies, public debt is expected to have reached 90% of gross domestic product (GDP) in 2019 – the highest level on record – while non-financial corporate debt reached 156% of GDP in China and almost 50% in the US, also the highest level ever recorded. For bond holders specifically, high leverage translates into increased default or downgrade risk.

The global default rates in the speculative grade or high yield market are still comparatively low at 2.8%, but have been on the rise recently. Tepid growth and low funding costs may support high yield issuers. But with record debt levels, the margins to serve debt payments are lower. While Moody’s in their base case scenario see the global default rate moving towards 3.3%, lower than expected growth or event risk have the potential to push default rates even higher.

The main risk for investment grade bonds is rating downgrades. With approximately 50% of listed bonds now rated BBB, a large wave of downgrades could cause spreads to widen significantly. According to Moody’s, however, 83% of investment grade bonds have maintained their rating 12 months into a recession in the past 30 years. It is encouraging to see that very large BBB issuers have put debt reduction at the forefront by selling assets or cutting dividends in order to maintain their rating lately.

Downgrades as well as default rates are likely to rise in 2020. While we favour investment grade over high yield, we would be selective in both markets. Selection is also important given the increasing dispersion in spreads within different issuers. In recent years the average spread of lower quality issuers vs. higher quality issuers in each HY market has increased significantly (see chart).

Increasing spread diversion chart

Market Perspectives February 2020

Barclays Private Bank investment experts highlight our key investment themes. Despite a strong start to 2020 by financial markets, trade tensions and rising geopolitical risks feed into a general feeling of apprehensiveness.


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