Just how low are yields?
Globally, government bond yields have remained incredibly low, despite the cyclical pick-up we have seen in economic growth in recent times. Nowhere is this more evident than the Eurozone, which continues to post strong economic data. Unemployment is falling, Gross Domestic Product (GDP) forecasts are increasing and various Purchasing Manager Indices (PMIs) show robust expansion. For example, data from the European Commission shows the Eurozone unemployment falling consistently from the end of 2012 to today.
Source: Statistical Office of the European Commission, standardised unemployment. Seasonally adjusted percentage of the civilian workforce, as at 31/07/17.
However, despite this more positive economic backdrop, safe haven investments such as government bonds have continued to prosper, with yields driven to exceptionally low levels. The German 10 year bund yield has not been above 1.0% since September 2014 and reached a nominal low of -0.2% in July 2016, following the Brexit vote. This is despite a slew of positive economic data since. Yes, bund yields have either been flat or gently rising for much of 2017, but they still remain far lower than they should be in our view. Even 10 year Italian bonds are currently yielding 50% less than they were just two years ago.
What has happened recently?
A couple of months ago, it looked like yields were back on an upward trend. More hawkish comments from European Central Bank (ECB) President Mario Draghi and Bank of England (BoE) Governor Mark Carney led the market to predict that monetary tightening – and thus the prospect of higher interest rates – could be on the way sooner than expected. This saw yields spike up globally and suggested we were on – an albeit gradual – path to a more normalised interest rate environment. However German 10 year bund yields have since fallen back from 0.6% to 0.4% as geopolitical tensions have risen, particularly surrounding the actions of Kim Jong-un in North Korea, and fiscal stimulus expectations have been pushed back.
Where are the opportunities?
Government bonds have struggled for much of 2017, with yields either treading water or rising gently. In contrast, corporate bonds have performed strongly, as they have continued to offer investors higher yields and a more attractive risk/reward profile. In particular, they have been beneficiaries of the ongoing European Central Bank (ECB) corporate bond buying programme. Globally, corporate bonds have far exceeded the returns of government bonds in local currency terms so far in 2017.
At Canada Life Investments, we adopt a macro approach to positioning the CF Canlife Global Bond Fund. For example, corporates historically outperform government bonds in times of rising yields – a time which we believe we are now in – whilst investing abroad allows you to benefit from currency movements. Currently, for example, we have a large allocation to European corporate bonds, as we believe that the euro can remain strong relative to sterling from a currency perspective, whilst European businesses are well placed to benefit from a supportive underling economy. In addition, the ongoing Brexit negotiations are expected to keep a lid on sterling for some time. As you can see from the graph below, spreads have compressed significantly since the middle of last year.
Corporate versus government bond benchmark spread
Source: Markit, as at 12/09/17. Semi-annual benchmark spread for the iBOXX Euro Corporate Index.
Furthermore, we believe there are even more attractive opportunities at a sector level. For example, utilising our macro approach and expectations of a higher interest rate environment, we prefer to bias the portfolio towards companies that benefit from higher rates, such as financials. In particular, we are keen on subordinated financials, which yield significantly more than broader corporates, as well as offering a shorter duration profile.
Over the last year we have even seen nominal government bond yields hit negative milestones. In reality, taking inflation into account, these yields have been negative for some time. This is understandable to some extent, we live in an uncertain world and investors are attracted to so-called ‘safe havens’. A combination of geopolitical uncertainty and a decade of quantitative easing (QE) has significantly distorted bond markets, with central bank balance sheets forcing yields lower. However, yields cannot continue to fall as they have over the last decade, indeed the US is already part way through a rate-rising cycle. As central banks withdraw monetary stimulus measures – which they will do at some point – yields must rise. In essence, bond markets need to catch up with the fundamental reality. In the context of this reality – which is a relatively strong global economy – government bonds remain overvalued. As an example, the current price-to-earnings ratio of the S&P 500 Index, widely considered the most expensive equity market, is 25x. Using the equivalent valuation for bond markets puts US treasuries at a rating of 46x and German bunds at a staggering 256x.
Therefore, we believe fixed income investors will have to work harder to generate outperformance, which we believe will come from country, currency and sector allocations – in addition to a robust credit selection process.
For the rest of 2017, we expect to remain in a macro environment featuring improvements in the underlying economic data, with the recovery being supported by expansionary fiscal policies in the US and in Europe. This should support a gradual rise in global bond yields. Uncertainty factors, however, remain given the political paralysis currently being endured by the Trump administration, as well as the Brexit overhang that we are witnessing in the UK. The CF Canlife Global Bond Fund continues to maintain a short duration positioning at current levels and an overweight allocation to corporate bonds versus government bonds. This has been beneficial for the Fund in 2017 year-to-date, with our 2.99% return ahead of the Citi World Government Bond Index’s 0.53% gain.*
*Source: Performance figures from Morningstar to 12/09/17. Bid to bid, with net income re-invested for C share class. Whilst the Fund does not have a specified benchmark, for internal fund management and performance measurement purposes we use the Citi World Government Bond Index as a neutral position for the Fund. Where benchmark is referenced in this document we are referring to this Index.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Currency fluctuations can also affect performance. The contents of this article are not intended as investment advice.
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