Tough sledging in fixed income markets. Yields are low with an expectation that they will rise in line with the steady improvement in global growth, yield curves are flattening which reduces the opportunity to seek higher yield through buying long dated bonds and credit spreads are widening. Finally, the divergence in monetary policy and hence yields between the US and everywhere else means that hedging the foreign exchange risk of investing in US bonds has become too large for most investors in Europe and Japan. For the technically minded, buying bonds overseas creates a foreign currency exposure that most investors will hedge using the forwards market. This incurs a cost, equal to the difference between the interest rates for the bond’s and the investor’s currencies at the point on the forward curve at which the contract expires.
The US 10 year Treasury yield touched 3% in April for the first time since 2013. This didn’t create the mass panic feared because by now it had been priced in by markets. The Federal Reserve is pushing up interest rates to maybe 2.5% by year end and above 3% next year, US nominal GDP growth is likely to be around 5% this year and a widening fiscal deficit means an increased supply of Treasuries to pay for the tax cuts just as the Fed itself is running down its own holdings. Against this backdrop a 3% 10 Year yield had become inevitable and not the demon once feared. As discussed above, hedging costs deter overseas buyers who otherwise would have found a 3% yield attractive
The flattening of the US yield curve means that US investors are not getting paid for the risk of buying longer dated bonds. A parallel 50bps increase in yield would deliver total returns (gain in income but loss of capital) of around 1.65% in the 1-3 year part of the curve but a loss of 2% at the longer end such that cash, Treasury bills and short dated bonds are all in vogue (thank you to Axa Investment Management for the calculations). The value of buying duration today is in its diversification; should the consensus be wrong and the US slumps into recession then the much maligned long duration bonds are suddenly going to look like quite a clever insurance policy after all.
We are in the early stages of a bond bear market but it remains for now a modest, shallow and unthreatening one. We have grilled our Fixed Income managers as to the terminal US yield for this cycle and the great and good of Fidelity, Artemis, Standard Life, Jupiter and JPM are of the opinion that, though the direction of travel remains upwards for the foreseeable future, the high point of the cycle for the 10 year US treasury will only be around 3.5%, way below the usual double digit peaks of previous cycles. The 3 Ds (debt, disruptive technology, demographics) are huge structural trends that should keep bond yields much lower than in previous cycle. The peak of improving economic momentum is now probably behind us leaving economic growth solid but not incendiary and inflation still muted even at this late stage of the economic cycle. This too 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. If the boffins are right, then the Fixed Income market is beginning to offer some value again without a huge amount of downside risk.
Non-bond market professionals (normal people in other words) tend to pay attention to movements in interest rates and the savvier still to the duration of their fixed income portfolios. They typically pay less attention to credit spreads (the differential in yield between a corporate bond and a Government Bond of the same duration) which is a measure of the additional price investors need to be paid for taking risk. The more investors are concerned as to whether their interest payments and capital repayment on maturity will be paid on time and in full, the wider the spread. In the super bond bull market of the last decade credit spreads tightened considerably to almost historic low levels (i.e. investors have needed minimal payment to take credit risk). As Central Banks begin to reduce their abundant liquidity support and the peak of the economic growth rate this cycle is probably now behind us then investors are starting to become more cautious about companies defaulting on their commitments to bond holders. Hence spreads are starting to widen again, which leads to a fall in the price of the bond. The tightest compression, and hence least value, has been in the High Yield area of the market and not surprisingly it is this area of the market where spreads are widening most rapidly.
Rising interest rates combined with widening spreads are a grim combination for credit market investors. If they are compounded by illiquidity in the underlying bond then this makes for a particularly wobbly tricycle. We don’t think you’ll see much in the way of gains in the big developed market Guvvies market, nor in high quality investment grade credit, but nor do we see significant downside risk. Our concern is in the more illiquid, lower quality reaches of the High Yield and EMD markets.
Summary: Long dated bond yields marked time in Q2 after the sharp spike in the first quarter and we expect similar for the remainder of the year. The long term direction of travel in yields does though remain gently upwards as global growth remains firm and Central Banks begin to gradually tighten monetary policy. Spreads are widening in Investment Grade and High Yield credit such that corporate bonds are underperforming Government bonds.