By Iain Stealey, fund manager, JPM Global Bond Opportunities Fund
If the past 30 years has been a one-way traffic for bond investors, the last six months have been anything but. Once perceived as dull if dependable shock absorbers for a portfolio, and a place to land when equities fall, bonds are recalibrating to a more volatile norm.
As Draghi warned investors earlier this summer, it’s time to get used to turbulence. For evidence of this, we need only look at the German 10 year bund’s worst 48 hours since the Euro inception recently.
In all of this, it is important to remember that higher volatility doesn’t limit the prospects for making money in bonds – in fact, in some ways it actually expands the opportunity set. What it does require is a strategic, unconstrained investment approach. Let’s consider what that means for investors in practical terms.
Taking a step back to review the macro outlook, we have a few factors at work driving global bond markets towards what we think is an interesting inflection point. In April, investors seemed to awaken to the realisation that a yield of .04% on German 10 year bunds was far too low, releasing the pressure valve to send yields soaring back up.
That in turn saw the sharp retracement in global benchmark yields and a return of investor consensus to focus on the US 10 year Treasury as the global barometer for bonds. So the question is – where is the yield on the US 10 year Treasury going?
It’s actually fallen dramatically over the last few weeks in line with the declines in oil prices, but we should look to history as a guide to the future direction of yields.
The US Federal Reserve has clearly telegraphed their intent to move very slowly and gradually on rate increases, ensuring at each step that the US economy is able to withstand the impact of rising rates.
They’ve also signalled that terminal rates will ultimately be lower than in past cycles, a stance that was reiterated by the Bank of England’s Mark Carney, who is calling for terminal Bank rate to be half that of its past norms.
So if we assume that the US Fed funds rate gets to around 3% at the peak of the cycle, that suggests the US 10 year Treasury will reach about 3% or slightly lower – not an enormously dramatic shift from where yields currently are around 2.2%. Put another way, concerns that bond investors will experience painful losses as yields jump seems somewhat overblown. Instead, we should expect to see a gradual and steady increase.
Therefore, if investors won’t lose too much by being in core government bonds, they aren’t going to make that much either. Investors are going to have to make their allocations work harder and they’re going to have to look farther afield.
Valuations are attractive in both European and US high yield debt, on both a spread and a yield basis. Currently we’re at an all-in yield of 6.9% on the US high yield index. We’ve seen a fair amount of disruption from falling oil prices hitting the energy sector, but recall this sector makes up only about 13% of the overall US index (much less in the European index), or about 50 basis points of the total yield.
We think the high yield credit cycle has further to go from here and isn’t overly threatened by liquidity concerns. Ultimately credit cycles are driven by default rates, which aren’t likely to rise until after the Fed has finished the rate rise cycle.
High yield also tends to be a resilient market because of its additional yield, and it’s an area that still looks attractive to us for strong returns.
We see a lot of opportunity in European bank debt. Significant deleveraging and a healthier outlook for the banks encourages us to hold debt further down the capital structure in names where we are comfortable with the fundamentals.
In the face of recent German bund yield volatility, spreads have been relatively stable in bank debt and it’s yielding around 5.8% at an index level. There’s opportunity if you can do the research in the credit structure in this space.
It is a more mixed picture in emerging markets debt, where commodity concerns are dragging on the markets whilst the pressure from a looming Fed rate hike drives concerns. We saw a period of significant inflows into EMD in the last few years as investors chased yields, a trend which has largely reversed as capital has returned to the developed markets.
Those ‘bond tourist’ flows haven’t come back to the asset class, leaving a cleaner market of underlying investors and a picture of attractive valuations. We’re approaching 7% yields on local EM debt and around 6% on US dollar denominated EM debt. Volatility here is sure to continue, but it will create idiosyncratic opportunities.
For example, if we look at it on a country-by-country basis, there is a huge variety of losers and winners from falling commodity prices. Having the flexibility to hedge currency exposure favourably around a strong US dollar story here is critical.
Taking advantage of today’s bond markets requires the ability to cherry pick the best ideas across the global landscape, agnostic of benchmark, region or sector.
Keeping close tabs on interest rate sensitivity is also important for investors today. For example, maintaining a low empirical duration (meaning exposure to moves in the 10 year US Treasury) can help shield the portfolio from losses when rates do move up.”