Back to the future

06 March 2020

4 minute read

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

The demand for bonds seems unstoppable in an environment where yields are cursed to stay lower for longer. The bond market is diverse and offers opportunities to lock in yields.

Rates: how low can you go

The US 10-year bond flirted with a yield of 2% in December on the back of robust US economic data and reduced trade uncertainty. Fast forward less than three months and the prospects for higher yields seem all forgotten while the US 10-year and 30-year yields have reached record lows of around 1.03% and 1.60% respectively. The global growth concerns sparked by the escalating Covid-19 virus outbreak have intensified the downward move in rates.

The US Federal Reserve (Fed) responded with an emergency cut of 50 basis points (bp) and justified this as follows: “In light of these risks [the Covid-19 outbreak] and in support of achieving its maximum employment and price stability goals”.

The Euro dollar future market is pricing in two more cuts over 12 months. The Fed clearly wanted to avoid a scenario whereby it is running behind market expectations as seen in 2019.

Given that only four 25bp cuts are left to hit the 0% mark, it is likely that the Fed will be prudent in using this ammunition. However, should inflation and inflation expectation remain below the central bank’s 2% target, a further cut within the next 12 months should not be ruled out.

Twisting and turning yield curve

For a period of time after the Fed’s 25bp cut in October, and subsequent rise in longer dated yields, the long-awaited normalisation of a steep yield curve seemed to have settled in again. However, the recent rate moves brought bond investors back to the harsh reality where the yield curve is inverted at least at the front end of the curve.

The “lower for longer” mantra persists as long as inflation, and inflation expectations, are not picking up towards or beyond the Fed’s target. It remains to be seen if a new approach to define the inflation target will change inflation expectations. For now, investors are most sensitised to subdued inflation which will likely keep bond yields lower for longer.

Opportunities in investment grade and emerging market debt

It is not a surprise that as the “goldilocks” scenario persists, where growth is moderate while the risk for substantial higher rates is low, investment grade, emerging market and high yield bonds are performing well. But given the tighter valuations, investors need to be even more selective.

Investment grade bond spreads keep grinding tighter. While some BBB rated companies might see less of a problem downgraded to non-investment grade status, the majority of the companies have successfully kept their ratings. Other companies have even been upgraded. We feel comfortable holding investment grade debt, but selection will be key.

Emerging market (EM) bond spreads have been remarkably resilient in the wake of the recent uncertainty. Apart from the Asian property sector, most names have held up well with EM bonds recording large weekly inflows, partly over $2bn recently.

EM bond spreads have been remarkably resilient

While spreads on the EM USD hard currency index are below their historical norm (320bp), yield levels are low at 4.6% on average. The flow from riskier assets to safe-haven ones has seen a substantial widening of spreads in the high yield market.

In Europe as well as the US spreads have widened by more than 100bp. Furthermore, with the average yield for US high yield now at around 6%, risk may be better priced and the period of expensive valuations resolved.


Market Perspectives March 2020

Financial market sell-offs, on concerns over the impact on growth of the spreading coronavirus, dented a strong start to the year and highlighted the attraction of diversified portfolios.


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