- As we have been saying for several quarters, this is a difficult asset class in which to make any money. Yields are low with an expectation that they will continue to rise in line with the steady improvement in global growth, yield curves are flattening and credit spreads are widening. In addition, the divergence in monetary policy and hence yields between the US and everywhere else means that the cost of hedging the foreign exchange risk of investing in US bonds has become too large for most investors in Europe and Japan. We see this trend of minimal and sometimes negative returns from Bond funds continuing, but there is unlikely to be any bursting of the so-called ‘bond bubble’
- It is only in the US where yields are ‘normalising’ in a relatively strong economic environment with the Fed raising rates and bond yields moving higher across the curve, especially at the shorter end. The renewed appeal of cash and short-term bonds is thus primarily a US story. Yields remain low in core Europe, UK and Japan because interest rates are still close to zero and many investors have been ‘short and caught’ by expecting higher rates, especially in Germany where the yield on 10 year Bunds is unchanged ytd at a miserly 0.45%.
- Government bond yields are likely to remain in the current relatively tight trading range for the remainder of the year, blown around by growth and inflation numbers, trade tensions and sundry geopolitical events but unlikely to make a quantum move that signals a change in trend. We still feel that long dated yields will move higher, though arguably little more in the US, and in this process value will begin to return to the long end of the market. The peak of improving economic momentum is now probably behind us leaving economic growth firm but not overly inflationary. This would imply that even though the Fed will keep raising the base rate, the long-end of the curve has already seen much of its likely move. History has shown time and again that long duration bonds are a very important diversifier in long term investment portfolios but the Central Bank QE has mis-priced bonds to such an extent over the last decade that they have lost this characteristic. A return to ‘properly priced’ Bonds would be very welcome and make our roles as portfolio constructors considerably easier – it’s always nice if you have a properly priced ‘safe haven’ as an investment option.
- I wrote at length about the flattening of the US yield curve and the possibility of its inversion last quarter but feel it deserves another airing given its much touted reputation as a recession indicator. Short term yields tend to closely follow the Fed and so have risen sharply in response to the rate rises but long yields have rather marked time around the 3% level as the market is not as yet overly concerned about inflation. As a consequence, the gap between two and ten year yields is as low as 25bps. The Fed is contemplating another four 25bps rate rises this cycle implying that two year Bond rates could be 3% by year end and climb higher into next year. Without a prolonged growth surge and inflation shock it is unlikely that ten year yields will be much above 3.25/3.50% this cycle implying an inverted yield curve at some point next year. Time to test the ‘an inverted yield curve indicates an imminent recession’ and the ‘stock markets peak six months before a recession’ hypotheses.
- Credit spreads have continued to widen this year (leading to a fall in the price of the bond) though not yet to the extent that they offer much in the way of value. As a consequence Corporate Bond and Strategic Bond funds have underperformed Gilts. Global investment grade spreads have only widened by around 20bps this year with the greatest damage being in the higher risk/reward sectors of the bond market with High Yield spreads widening by around 40bps and EMD (US$) by 50bps.
Summary: The long term direction of travel in bond yields remains gently upwards as global growth remains firm and Central Banks gradually tighten monetary policy. Spreads are widening in investment grade and High Yield credit such that corporate bonds are underperforming Government bonds.