A little over three years ago, our weekly view titled “The Bond Market Conundrum” highlighted the challenges facing fixed income investors at a point where core government bonds traded at historic low yields, trillions of Dollars in debt instruments were offering negative nominal returns and talk of a shift in monetary policy towards “rate normalisation” was in the air.
Within that piece, we advocated a defensive approach that relied on the proven skills of managers with unconstrained flexible mandates, or specialised strategies that focused on low duration (i.e. sensitivity to interest rates), offered strong asset backing and / or floating coupons. Emerging Markets and High Yield, we noted, also offered opportunity by virtue of their attractive yields and relatively cheap valuations.
Much has happened in the intervening period from economic, monetary, geopolitical and market perspectives that would take a whole series of weekly views to cover. Revisiting that article thirty-eight months on, however, despite markedly disparate macroeconomic backdrops, there are interesting similarities between today’s bond market and the one we previously wrote about, as well as some notable differences.
In terms of parallels, valuations in many areas are remarkably similar: ten-year US and UK government bond yields, are respectively just ten and five basis points (bps) above those September 2016 levels. Meanwhile, the total value of debt trading at negative nominal yields is and was around the USD12 trillion mark – nowadays there’s a Bloomberg / Barclays index which measures that number, but back in 2016 that calculation was a bit more of a “thumb suck”. Within corporate bond markets, there is also very little difference in the level of investment grade credit spreads in both the UK and Europe.
By contrast, the most pronounced differences are to be found in the High Yield space, particularly at the bottom end of that particular credit spectrum. In the US, for example, the average BB rated issue is now priced 96bps more expensively relative to US Treasuries and CCC rated bonds are 134bps dearer; in Europe, the corresponding figures are -41bps and -220 bps. While not quite to the same extent, Emerging Market (EM) sovereign debt has also tightened in relative terms, with the current yield differential between the JP Morgan EM Bond Index versus Treasuries some 35bps lower than in Q3 of 2016.
What the above figures don’t tell us, of course, is what happened in markets over the past 3+ years. As the charts below show, our strategy has proved effective over a period that has encompassed two very different market environments, with the fixed income component of our GBP and USD models outperforming broad bond indices in absolute, relative and particularly volatility-adjusted terms (in the interests of balance, it must be said that we were way too early in adopting that defensive positioning).
MO GBP Fixed Income vs iBoxx UK GBP All Maturities
MO USD Fixed Income vs Barclays US Aggregate
Source: Financial Express
So with the global monetary policy pendulum having swung back to “loose” after a brief(ish) period of tightening, is our strategy still relevant for the current market environment? We certainly think so. The diminishing beneficial impact of each successive policy loosening by Central Banks suggests that it may not be long before QE gives way to fiscal management as the preferred method of economic stimulus. This, combined with richer valuations in, for example, High Yield, means that the pickings within fixed income markets are as slim as they have been for some considerable time. Crucially, that is not to say that bond markets are a no-go area or an accident waiting to happen – rather, and as before, they require a considered approach and a bit of lateral thinking.
Download: Weekly comment, Shaun McDade – 18112019
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