Investors re-evaluate bonds in light of negative yields
Declining yields have been a feature of bond markets for decades, but with more than a quarter of the debt issued by governments and companies around the world now trading with negative yields, investors are having to reassess how they incorporate the asset class into their overall portfolios.
With both the US Federal Reserve and European Central Bank having reversed their direction of travel and indicating they are once more in the process of rate cutting and bond buying, the situation looks likely to continue for the foreseeable future.
The most important feature this year for investors has been the decline in global bond yields and the duration rally, says David Riley, chief investment strategist at BlueBay Asset Management.
“The big question for markets is are we in a world of low and negative rates as far as the eye can see with QE infinity and if so how should fixed income investors adjust to that reality?”
Both institutions and HNWIs have been rotating out of government bonds and into investment grade, he reports, but also into private markets.
“I think the state of fixed income markets has reinforced the trend for a lot of institutional investors, but increasingly private wealth investors, to move from public into private markets,” says Mr Riley.
He admits there are opportunities to be found, but warns some of these markets have not yet been fully tested and they are much less liquid. “As we found in the financial crisis, people tend to underestimate the value of liquidity until they need it.”
Some investors are liability matching, and holding negatively yielding debt still makes sense for them because they need duration, explains Mr Riley, while, in this era of heightened regulation, government bonds have a special status as a “safe” asset. But those who are less constrained and more focused on return maximisation have much less compelling reasons to invest in fixed income markets, he adds.
“That said, government bonds still provide diversification against the equity risk in your portfolio,” says Mr Riley. “And so those fearful we are going into a global inflationary recession, from a capital preservation point of view, even Bunds will be a more attractive option than, for example, holding European bank stocks.”
All change
A year ago, things were very different for the bond markets, reports Cathal Dowling, product director, fixed income at Invesco, as central banks were gradually withdrawing from their post-crisis, QE role.
“People were wondering how are the markets going to react without the central banks behind them? We had some patchy data, quite a spread widening in the credit markets, yields rising, and actually, as a fixed income manager, especially in credit, we were enjoying that environment. We were seeing lots of opportunities. Some decent yield for the first time in years.”
How things have changed. First the Fed stopped hiking rates, and has since moved to cutting, with the market pricing in more of the same. Meanwhile the ECB has become more supportive as well.
“So we are back in the situation we were in a couple of years ago, or at least it certainly feels like that,” he says. “Now we have that fire blanket that has been thrown over the market by central banks, yields have come down, spreads have tightened a bit, and there is less opportunity.”
Not everyone has welcomed the central banks’ change in direction. Some doubt whether the ECB in particular have the ammunition available to boost growth, rather pointing to the need for governments to take up the baton through fiscal easing. But others believe the process has been flawed from the start.
“I am very critical towards what the ECB has done,” says Tatjana Greil-Castro, who runs the enhanced yield short-term strategy and the bond yield ESG strategy at Muzinich & Co. “I don’t think it is helpful. It does not mention the broad investors. I think that when it set out with QE a few years ago, it was saying we want you all to go into risky assets. Well now it is asking investors to go into risky assets and pay for the privilege. They are not expected to make any returns. That is too much.”
While the ECB is very happy to convince themselves that its policies have had a positive impact, she questions that and asks what time horizon is it being judged against? “If we look a few years down the line and the asset bubble it has created has burst, then maybe the costs will be higher than the short-term relief that it may have helped to generate.”
The lack of yield has a lot of unintended consequences, warns Ms Greil-Castro, with bond investors unwilling to take any risks because they do not have the cushion of higher yields to compensate for the odd loss they may take. And the European high yield market is now seeing companies going into bankruptcy, notably travel company Thomas Cook, she says.
“Companies are getting into difficulties and there are no investors willing to support them, because everybody is saying they don’t have room to take those risks. So it becomes counter intuitive.”
With yields so low in investment grade, the only way to boost income without taking on more risk is to cut out anything that is negative yielding, or zero.
“That cuts out around half of the universe. But then we focus on credit worthy names, which may have a yield of maybe 1 per cent, or in high yield 2 per cent, but are very likely to make the indicated return. And by saying no to the negatively yielding names, you are actually lowering your risk.”
It is the overall risk of your portfolio that is important, not allocation to treasuries or emerging market debt, argues Ludovic Colin, head of flexible bonds at Vontobel Asset Management.
“Focus on risk. That doesn’t mean don’t take risk, rather take risk that pays you in an efficient and fair way,” he says.
Vontobel has no exposure to investment grade, explains Mr Colin, because at some point these papers will create low performance. “They just aren’t a good investment opportunity,” he warns. Parts of emerging markets on the other hand come with good coupons and high fundamentals.
“On the sovereign side we like parts of Africa, Brazil, Mexico and Russia. They give you a good yield and the volatility of these papers is relatively small.”
There are also some corporates in emerging markets with better balance sheets than most high yield in developed markets, says Mr Colin. “They have stable balance sheets and sit in growing markets. They are better investments.”
Emerging market debt offers strong opportunities for investment portfolios, agrees Marshall Stocker, director of country research and portfolio manager at Eaton Vance, but warns that benchmarks are “woefully inadequate” for covering this space, as they are generally either very concentrated or have quite a bit of developed market risks seeping into them.
Emerging markets, both in equity and fixed income, tend to have some of the highest forecasted returns, but the perception of volatility puts off investors, he claims.
“Volatility means you may not achieve the excess returns in any single period, but volatility is frequently driven by poor economic policy,” says Mr Stocker. “If you can identify countries that are improving in economic policy, then you wind up with a less volatile return stream.”
The approach at Eaton Vance is to try and forecast government policy through having an in-country presence in these markets and talking to a range of people, from government officials through to journalists and NGOs. “That enables you to build up a mosaic. It is the direction of change that is the important thing.”
Although most forecasts suggest that a recession is not imminent, there are huge vulnerabilities to a downturn, warns Madeleine King, co-head of pan-European investment grade research at Legal & General Investment Management, because company balance sheets are in the worst position they have been in for a very long time.
“Even if we avoid recession we are looking at well over $100bn in downgrades from investment grade to high yield globally. That is matching the levels seen in the financial crisis and the energy driven downgrades of 2015. But if there is a global recession, we get to well over $400bn of downgrades. That is unprecedented. How would the markets cope?”
These numbers are so high because the bond markets have grown enormously over the past 10 years, and it has been driven by the low end, the BBBs, rather than by high quality issuers.
“If we head into a recession before companies have had a chance to repair their balance sheets, or before central banks have given them the incentive to, then we might be in the position where the high yield markets have an awful lot of debt to absorb,” she warns.
Safety net
Given the current stage of this business cycle, RBC Wealth Management is positioning itself in anticipation of a possible economic downturn, which is making bonds more attractive from an overall portfolio perspective.
“Up until the beginning of this year, many investors were positioned to benefit from an ongoing move higher in equities,” says Alastair Whitfield, head of fixed income, British Isles, at RBC Wealth Management. “While we have been of the view that equities have the potential to still perform from here, we are cognisant that the potential for drawdowns in the market remains front and centre of investors’ attention given the pickup in volatility. We have consequently seen a notable amount of interest from clients wanting to dial down their risk exposure, while we also are positioning more conservatively.”
In this context, investors are still looking to fixed income for the relatively low risk characteristics of capital preservation and consistent income generation for which it has always been perceived, he says. Although the opportunities are becoming less obvious, RBC does like certain emerging markets, as well as alternative structured credit strategies.
Citi Private Bank is neutral equity and underweight fixed income, mainly because it finds European sovereign bonds so unappealing, says its head of EMEA investment strategy, Jeffrey Sacks. He expects prices to go higher, and yields lower, and is not advising clients to chase that rally.
However he does see three areas globally where there are opportunities for positive yield, despite the current environment: emerging market debt, US investment grade and European high yield.
In terms of European high yield, the sluggish and weakening economic environment may not be great for equity investors, but it is great for corporate credit because it keeps defaults low and corporate leverage low. “We think that gives us a fundamental backdrop for looking at high yield as an area with further to go,” he says.
The ECB’s renewed buying should also provide a trickle down effect, says Mr Sacks, as it will continue to buy into the sovereign and investment grade bond markets, and the sellers of those bonds will be looking to use the cash to continue to hold fixed income assets, and will be forced into European high yield.
Meanwhile the opportunity to hedge back into dollars is appealing at the moment. “On an unhedged basis you are getting 3.7 per cent on average, when hedged you are approaching 6 per cent. That is quite decent,” adds Mr Sacks.
But he warns that as the economic cycle nears its end, investors need to look for companies where they have comfort in balance sheets and cash flows. “We would increasingly look for higher quality within the European high yield space. Focus on high yield, but the higher quality end.”
VIEW FROM MORNINGSTAR: Markets endure heightened volatility
Global bond markets exhibited elevated levels of volatility over the last 12 months. In Q4 2018, investor sentiment was negatively impacted by a number of factors including the ongoing US-China trade tensions, the pace of interest rate increases by the Federal Reserve and uncertainty surrounding Brexit negotiations and Italy’s budget. This meant developed markets government bonds benefited from safe-haven flows over that period.
At the same time, credit spreads widened, so corporate investment grade and high yield bonds across the US, non-US developed markets and emerging markets suffered.
But so far in 2019, risk appetite has generally increased. A more optimistic outlook on the US-China trade negotiations, a dovish shift in US interest rate policy, better than expected macroeconomic data and strong corporate earnings announcements led to spread tightening and a solid recovery for investment grade and high yield bonds.
Strong inflows across bond categories in developed and emerging markets, reflecting investors’ appetite for yield, were also supportive. Yet, there were also short spells of risk aversion in May and August. These were marked by spread widening, driven by tariff hike announcements in trade negotiations, concerns over weakening global growth and country-specific issues.
US government bonds yields have fallen as the Fed initially adopted a more accommodative stance and then announced rate cuts in in response to soft macroeconomic data and trade conflicts. Core European government bond yields also fell, driven by the ECB’s announcements of additional monetary stimulus. In August, Germany issued negatively yielding 30-year government bonds for the first time. Italian government bonds rallied as they attracted yield-searching investors after the budget approval by the EU and the formation of the new coalition government.
The PIMCO GIS Glb Bd Instl EUR Ccy Exps Acc has been managed by Andrew Balls, Pimco’s CIO of global fixed income, since September 2014. He has run this fund with two comanagers Sachin Gupta and Lorenzo Pagani and they are also backed by Pimco’s strong resources. The process is based on the firm’s top-down views driven by the investment committee on which Mr Balls sits which guide the fund’s decisions.
Within the scope of those themes, Mr Balls and his team consider relative valuations to determine sector, country and yield curve positioning. During his tenure the fund has outperformed the US dollar-hedged Bloomberg Barclays Global Aggregate Index and its average peer group.
iShares Overseas Govt Bd Idx (UK) X Acc has benefitted from investors’ move to low-fee offerings and is currently the largest passive fund in the Morningstar Global Bond category. It is managed by experienced portfolio manager Francis Rayner and the wider EMEA Portfolio Solutions Team. Its investment process is highly automated, with a key focus on minimising trading costs.
The exclusion of the UK is statistically significant as it can represent up to 10 per cent of a global developed sovereign bond index, and so investors have more comprehensive options elsewhere. This also results in a more volatile risk/return profile relative to peers, both passive and active. The fees charged by its clean share class are low relative to the category average.
Evangelia Gkeka, senior manager, research analyst, Morningstar
