Fixed income markets have become even more unimaginable as interest rates head lower and the amount of debt with yields below zero higher - the amount of negative yielding bonds now tops US$17 trillion, which is over a quarter of the global bond market. Bond yields continue to lower because of the shift back to quantitative easing (QE) by central banks this year. The US Federal Reserve cut its main interest rate in July while other central banks continue to debate QE and some suggest negative rates could happen. In Europe, European Central Bank (ECB) President Mario Draghi continues to hint at additional monetary stimulus for the region before his term at the ECB ends in October.
More bizarrely is that spreads in Europe are now lower than in the US even though by virtually all measures the forecasts for the European economy are worse than those for the US. Another surprise was the 10-year Greek government bond yield which recently dipped below that of the US 10-year Treasury note even though Greece has a significantly lower credit rating, much higher unemployment as well as a shrinking economy compared to the exceptional economic growth in the US over the past decade. It goes without saying that Greece has been in default for half of its time as an independent country, so in normal times would be viewed as the riskier high-yielding bond. With central banks expected to resume asset repurchase programmes, other government debt markets are likely to hit the zero mark. The entire set of German government bonds from three months to 30 years now offers negative yields for the first time ever. UK 10-year gilt yields are also currently at a record low of around 0.5% on the 14th of August.
Such drastic developments in fixed income have forced hungry investors to take on more risk in their search of positive real returns and this also has resulted in a narrowing gap between high-yield and investment grade (IG) debt. At the moment only 60 basis points separate BBB rated corporate bonds, the worst on the IG scale, from BB rated bonds, the best in the riskier high-yield category. This means that the difference between the good and the bad when it comes to credit quality has lessened significantly this year. The bizarre behaviour in fixed income has affected other assets too: as much as 60% of stocks in the S&P 500 offer a dividend yield of at least 1.7%, better than the current yield on the 10-year US Treasury in mid-August.
Navigating the shifts
Moving into the second half of this year, our fixed income managers are maintaining their overweight on fundamentally strong corporate credits versus government bonds, particularly in Europe given the amount of negative sovereign yields and our expectations of the restart of QE by the ECB. We believe this shift in monetary stance with central banks stems mainly from the resurgence of recessionary fears fuelled by ongoing trade tensions between the US and its main partners (China, Mexico, Canada and Europe), a sharp slowdown in the manufacturing sector (particularly in Germany) and the lack of agreement between the UK and the EU on the terms for Brexit. This has resulted in investors buying all types of fixed income instruments on the expectation of central banks’ support and therefore has pushed yields into negative territory or towards multi-decade lows. Corporate bonds have benefited as more investors add risk to their portfolios. We expect this outperformance of corporates to continue but believe that ambitious market expectations regarding yields will not be met, i.e. yields should rise from current levels.
In this regard, we have maintained our exposure to sectors such as subordinated financials and BBB rated issuers, as they have been the prime beneficiaries of the search for yield. We have also moved from c. 2 years short of the benchmark duration to 1.5 years short in recognition of the more dovish central bank environment. However, our overall short duration position is maintained due to our medium-term view that yields will rise from here. Our new purchases have been at the long-end of the curve – which has outperformed – with a clear focus on quality (e.g. Berkshire Hathaway) and non-cyclicals (e.g. Fidelity National Information Services & Telefonica) given the mature stage of the cycle.
Source: Bloomberg, at 14/08/2019
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CLI01479 Expiry 31/12/2019