- Slowing global growth, falling inflationary expectations, increasingly dovish Central Banks and a political backdrop that has become increasingly fraught, have led to a bumper year thus far for Bond investors with yields plummeting during the quarter. This is an environment that favours longer duration and higher quality credit. Despite the big ‘risk-off’ move in May credit spreads have still contracted in the first half of the year so corporate bond investors are feeling pretty happy as well.
- Bond markets are absolutely screaming to Central Banks that the global economy is heading towards the buffers and that Trump’s policies on trade, China, Iran and pretty much anywhere else are greatly detrimental to business confidence and global growth.
- German 10 year bunds are at an all time low of -30bps with a negative yield up to 15 years on the curve. Switzerland, Holland and Japan all have negative yields as well. UK Gilts are below 1% again and 10 year US Treasury yields have fallen sharply back to 2% with the yield curve inverted between 3 months and 10 years, a traditional indicator of future recession.
- While Bond yields this optically low may look impossible to sustain it is important to remember the number of ‘non-economic’ buyers distorting the market at a time that the demand for yield is in any case so high. Central Bank buying is the most obvious example, but in addition Commercial banks want to hold the safest of assets, Government Bonds, as long as there is a pick-up over their cost of funds, whilst Pension fund regulation has created a huge demand for low risk, long duration assets.
- Credit spreads continue to contract with global investment grade tightening by around 35bps ytd (to 120bps over Government Bonds) and the lower quality/higher risk Global High Yield by 120bps to 420bps. This actually feels a bit complacent as these spreads are towards the tight end of the range historically at a time when, if growth does slow dramatically, the default rate will surely rise.
- Valuation of credit is thus looking expensive, so too Governments which look super expensive on any long-term chart, and may well get more expensive still. At some point valuations will become an issue but that doesn’t seem to be any point soon. Growth optimism will need to improve, inflation expectations to rise and political risks to fade. Hmm, none of the above seem on the immediate horizon.
- Once again, the substantial gain in the price of long dated bonds during May as equities struggled showed that the most effective hedge against weaker risk assets remains long duration Government Bonds.
- As we noted last quarter, one of the features of Fixed Interest markets this year has been the strength of index-linked Gilts. This may appear surprising given that inflationary expectations remain muted but the reason is that in a quarter of falling yields, investors have been paid for holding long duration and linkers are the longest duration bonds of the lot. Conventional UK Gilts have an average duration of around 9 years, for linkers it is closer to 25 years!
Summary: This year is proving to be a bumper year for Bond investors. Bond yields have collapsed as the outlook for global growth has deteriorated and Central Banks, especially the US Federal Reserve, have turned increasingly dovish. Bond yields look set to remain at very low levels for the foreseeable future. When also adding in the benefits of ‘risk-off’ protection and the income from coupon clipping the outlook continues to look healthy.