Investment Strategy:  Fourth Quarter 2019 – Fixed Interest

Fixed Interest

• Bond yields collapsed in the summer (prices soared) as global growth slowed significantly, Central Banks became increasingly dovish both in rhetoric and action and geopolitical worries multiplied. August saw the best total return month for the global aggregate bond index since November 2008, and we all know what had just happened then. Yields backed up to an extent in September but this remains a bumper year for bond investors following the surge in demand for safe assets. 10 year yields fell to all-time lows of 1.4% in the US, 0.4% in the UK and, amazingly, -0.6% in Germany. Whole swathes of the global government debt market have negative yields which means investors are in effect paying for the privilege of lending to the government. Crazy.
• Bond yields have also inverted in several markets including at one point the US. Normally longer dated yields are higher as investors expect to be compensated for taking the added risk of holding bonds for longer. When the curve inverts (i.e. 2 year yields are higher than 10 year) it shows that investors are happy to buy long term yields today because they expect them to be even lower in the future anticipating deflation and further interest rate cuts by the Central Banks. Yield inversion is seen as a classic harbinger of recession.
• The longer the duration, the greater the sensitivity of price moves to changes in bond yields. As a rule of thumb this is 1% for each year of duration, thus if bond yields fall by 1% this would be a 10% rise in the price of a bond of 10 year duration but just a 2% rise for bonds with a 2 year duration. Thus, to protect portfolios investors are buying bonds of longer and longer duration, meaning that the yield curve has become lower as well as flatter and in some cases inverted.
• The question is whether the bond markets have over-reacted and priced in too deep a recession and long term disinflationary environment. Our sense is that the ‘lower for longer’ growth, interest rates, inflation, bond yields narrative will persist but that we are not entering an economic ice-age. Thus, we were not surprised to see bond yields backing up somewhat in the last few weeks of the quarter, but we expect that they will plateau at low levels pretty much indefinitely. A reversal to a cycle of rising bond yields requires the economic data to look significantly rosier, inflation to pick up, a cessation of the US/China trade-war, a resolution to Brexit and promise of concrete fiscal stimulus, some wish list! The ‘normalisation’ story of 2017/18 has not played out as history would have expected.

• The credit market is less gloomy than the government bond market, welcoming the fall in Government yields but taking an optimistic view on default risk despite the deteriorating outlook for growth. 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 80bps to 470bps. Falling yields/tightening spreads is a ‘win, win’ for corporate bond investors but with yields at super-lows and spreads near historic tights this feels a touch complacent. It is difficult to see significant further gains in either the Government or credit markets for the remainder of the year.
• Valuation of credit is thus looking expensive, so too Governments which look super expensive on any long-term chart. At some point valuations will become an issue but that doesn’t seem to be any point soon.
• As we noted several times before, 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 11 years, for linkers it is closer to 25 years.