A Time of Transition for Fixed Income
The fixed income era now ending could be summed up this way: much lower rates, but much greater size and complexity. A flood of issuance in credit and emerging market debt has greatly expanded the market. New cross-currents created by historic injections of central bank liquidity – as well as by demographics, technology, and regulation – have made it more complex. A transition is under way as monetary policy normalizes, liquidity ebbs, and bouts of volatility are roiling the market. The implications for fixed income investors are significant.
Government Bonds: A Global Look
A worldwide sell-off took hold of government bond markets in September against a background of closely-watched central bank decisions. Out of the 18 benchmark bond yields examined by Tradeweb each month, 15 saw increases and 13 had double-digit rises.
The U.S. Federal Reserve continued to normalize monetary policy, shifting the federal funds target to 2.0-2.25%. The mid-yield on the 10-year Treasury ended the month 20 basis points higher at 3.06%. Its Canadian counterpart also climbed 20 basis points, finishing at 2.43%. The Bank of Canada left rates unchanged on September 5, following a 25 basis points hike in its previous meeting.
Similarly, the European Central Bank held its main rate steady at 0%, and reaffirmed its plans to keep it low until the summer of 2019, even as it reduces asset purchases and will likely end them completely in December. Ten-year mid-yields for Austria, Belgium, France, and Ireland all rose by double-digits, while those for Germany’s 10-year Bund increased by nearly 15 basis points to close September at 0.48%.
Amid ongoing Brexit negotiations, the Bank of England also left rates on hold at 0.75%, following August’s increase from 0.5%. The UK 10-year Gilt yield rose by almost 15 basis points to end the month at 1.58%. Its Swedish equivalent also increased by nearly 14 basis points to close at 0.63%. Like the ECB and BOE, the Riksbank kept its benchmark interest rate steady at -0.5%, where it has been since early 2016, but indicated it might raise the repo rate in either December or February.
However, Finland’s 10-year bond mid-yield saw the largest overall increase of 27 basis points over the month, closing at 0.73%. Ratings agency S&P maintained the country’s AA+ rating citing a stable economic outlook.
In contrast, Portugal’s 10-year government bond yield fell by almost four basis points to 1.88%. Mid-yields for Italian and Greek 10-year debt dropped even more by approximately 9 and 22 basis points to end September at 3.14% and 4.15%, respectively. Italy’s newly-formed government tensely negotiated budgetary plans with the European Commission during the month. Activity in Italian government bonds surged on Tradeweb on the last trading day of September, with approximately EUR 5.5 billion in executed volume.
In the Asia-Pacific region, the Reserve Bank of Australia kept rates at an all-time low of 1.50% for the twenty-fifth month in a row. The mid-yield on the Australian 10-year note climbed 19 basis points to 2.67%. In Japan, 10-year government bond yields finished September at 0.12%, their highest level since January 2016.
Seeking resilience in fixed income portfolios
As they strive to stay on top of the market transition, most fixed income investors are also keeping a wary eye on geopolitical risks and wondering how much longer an already lengthy economic expansion will last. To state the obvious: they have much to consider.
Where should investors focus their attention? What steps can they take to make their portfolios more resilient? We asked four BlackRock CIOs to share their views. They are (from left to right below) Rick Rieder, Chief Investment Officer of Global Fixed Income; James Keenan, Chief Investment Officer and Global Co-Head of Credit; Tom Parker, Chief Investment Officer of Systematic Fixed Income; and Peter Hayes, Chief Investment Officer and Head of the Municipal Bond Group within Global Fixed Income. Excerpts from their remarks follow.
Rick Rieder: I think reduced liquidity is a major contributor to this year’s market stress points. Essentially, central banks are handing off liquidity provision to organic sources. The transition is likely to succeed, but it’s making for a more volatile market because any proactive reduction in the total global liquidity pool impacts a very broad set of economies and asset classes. When Italian bonds sold off last spring after the new populist government was formed, the spike in yields reflected reduced market liquidity as well as structural problems like Italy’s high sovereign debt load and budget difficulties. We’ve seen similar dynamics in bond selloffs in some emerging economies.
Understanding the changing liquidity regime probably matters more for investors than headline events such as how many rate hikes the Fed implements. Investors who underestimate the risks surrounding liquidity and who position too aggressively, or in too concentrated a manner, could run into trouble.
For building resilience, I’ll cite the important contribution that shorter-end Treasuries can now make to a portfolio. They are offering greater cash flow per unit of risk than other fixed income assets. We continue to think a barbelled portfolio makes sense, with less-risky front-end assets for carry, and some smaller notional contribution from riskier assets. That could mean selected credit or equity, and we also see value presenting itself in some parts of the emerging market debt world.
Tom Parker: There’s no question that late-cycle investing presents challenges. The greatest mistake I have seen investors make is accepting too little return for taking on risk. The reach for yield, the power of FOMO – fear of missing out – as well as increasing adverse selection in debt underwriting and the need to put cash to work all push investors into taking on more risk as the cycle ages.
The problem is how not to be dependent on timing. To instead create a risk-return profile that pays you to wait as the expansion matures, and has a good upside profile when the cycle weakens. A good way to do this is to use dispersion to your advantage, and to remember that as the cycle advances, dispersion tends to increase. At present, two sources of dispersion can be especially helpful. One is record-high levels of corporate leverage. While interest coverage is generally good, the leverage still makes companies more fragile, and helps separate winners and losers from a credit perspective. The other source of dispersion is the long-running trend of technology disruption, where you see tech-enabled disruptors increasing their productivity advantage over the laggards in sectors such as pharma, media, retail and energy.
In systematic fixed income, we use quantitative tools to create predictive insights and devise strategies that benefit from rising levels of dispersion.
Peter Hayes: Over the last decade many investors moved outside their comfort zones, taking more duration risk or credit risk than they would in a higher-yield environment. Now it’s time to consider how portfolios might behave as normalization proceeds.
In municipal bond portfolios, we recommend moving up in quality. We still see opportunities in lower rated credits, and lower-rated investment grade and high-yield assets still have a role because income is an increasingly important part of the return equation. But these lower-rated credits should be a smaller proportion of the portfolio, and investors need to be more selective. They should also be mindful that the price return has been harvested, and the returns will really be based on the coupon.
Hedging duration is another way to build in more resiliency. So is managing risk with a barbell curve emphasizing the short and the long end, as opposed to overweighting the belly of the curve, where negative term-premium unwind will be the greatest as central banks continue to normalize monetary policy. Investors should also be aware of one other major change. Whereas for years, market performance has been largely driven by greater demand than supply and other technical factors, underlying fundamentals will take center stage in the next downturn. Knowing what you own is becoming essential, and understanding all of the risks associated with later-cycle issuance patterns is paramount from both a performance and liquidity standpoint.
James Keenan: We expect rising rates to cause tighter liquidity and increase dispersion, which will create opportunities to generate alpha. We recommend positioning for this shift by moving up in quality and reducing duration. This will help to mitigate against unintended, idiosyncratic risks, and interest rate uncertainty.
This positioning leads us to leveraged loans and CLOs, which offer the downside protections of floating rates and a senior position in the capital structure. We’re not the only ones interested in these assets, of course. Investor demand has been strong, spreads are tight, and 2018 institutional leveraged loan issuance—which totaled $357 billion as of September 25, according to S&P LCD—may surpass 2017’s record. But both high-yield bonds and leveraged loans have historically performed well in a climate of gradually rising rates, which we expect. Finally, we think it’s important to pay attention to technical factors. We expect supply to be the biggest factor in second half performance.
We think increased volatility will be a hallmark of this period of quantitative tightening. There are technical reasons—supply and demand within asset classes, liquidity—and flare-ups of geopolitical risk will be a factor too. We also see investors becoming more attuned to company-specific information, and to idiosyncratic events.
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State of Play: China
Many fixed income investors have skin in the game regarding trade tensions between the U.S. and China, often in ways that don’t immediately pop to mind — if the tariffs have any negative effect on consumption, governments could take hit via knock-on effects to sales tax revenue, perhaps even income taxes should the economy slow. For the latest, we turn to Andy Rothman, an investment strategist at Matthews Asia. Prior to joining Matthews Asia in 2014, Andy spent 14 years as CLSA’s China macroeconomic strategist where he conducted analysis into China and delivered his insights to their clients. Previously, Andy spent 17 years in the U.S. Foreign Service, with a diplomatic career focused on China, including as head of the macroeconomics and domestic policy office of the U.S. embassy in Beijing. Here’s his latest take on what’s happening in China.
No credit stimulus (yet): There are no signs of credit stimulus from the Chinese government because it seems comfortable with the health of the economy. The growth rate of aggregate credit has slowed gradually, in line with slightly slower nominal GDP growth.
In September, bank loans outstanding rose 13.2% YoY, the same pace as a month earlier and roughly the same as a year ago (13.1%). Another key metric, outstanding augmented total social finance, which includes non-bank credit and municipal bonds, was up 11.2% YoY at the end of last month, slower than the 12.9% rate a year ago.
As I noted in our analysis of the second quarter data, there has been a dramatic change in the composition of credit, as China’s central bank has worked to reduce systemic risk. New issuance of bank wealth management products and other shadow banking activities have been sharply curtailed. As a result, the share of total credit coming from traditional bank lending has surged to more than 80%, up from 51% five years ago.
This has reduced financial system risks, but it has also meant that the companies and consumers who relied on non-standard credit sources have struggled to get access to credit. The central bank has acknowledged this unintended consequence and has begun efforts to mitigate the problem, without turning the shadow banking taps back on.
Trump Tariff update
The short-term direction of U.S.–China relations is difficult to predict. There are clearly many in the Trump administration who advocate disengagement from China and escalating the tariff tantrum into a trade war. Others, however, are working to negotiate a better trade deal, ahead of a planned meeting between Trump and Xi Jinping at the end of November, at the G-20 Buenos Aires summit.
My base case is that Trump and Xi will reach an agreement in the coming quarters, but if I’m wrong, and the dispute does escalate into a real trade war, there are a few key points to keep in mind. Most importantly, the Chinese economy is no longer export-driven, so the impact of a trade war with the U.S. would be modest. Net exports (the value of a country’s exports minus the value of its imports) account for only 2% of China’s GDP, down from a peak of 9% in 2007. In contrast, domestic consumption now accounts for the majority of China’s economic growth and more than half of its GDP.
Moreover, China’s exports to the U.S. accounted for only 19% of total Chinese exports in 2017.
Much of the impact of Trump’s import taxes will not be borne by Chinese companies. About two-thirds of the largest exporting companies based in China are foreign-owned. (American firms will be among the casualties in a trade war. For example, according to The Economist, “of the production facilities operated by Apple’s top 200 suppliers, 357 are in China. Just 63 are in America.”)
Chinese exporters are not yet suffering. Exports to the U.S. rose 14% YoY in September, the fastest pace of the last seven months, and roughly the same as a year ago. But when exports to the U.S. do decline, I have no doubt that Xi’s government will step in to provide financial aid to any Chinese companies that are hurt by the Trump tariffs. With central government fiscal revenue up by about 10% YoY this year, the fastest growth rate in seven years, Beijing has the resources, as well as the political will, to support domestic firms and mitigate the impact of weak exports, just as it did a decade ago during the Global Financial Crisis. As a result, I do not believe a trade war would cause significant damage to the Chinese economy.
ETFs Loom Large in Institutional Bond Portfolios
Investors’ need for new sources of liquidity has helped drive the rapid expansion of bond ETFs globally within institutional portfolios. Nearly 60% of the institutions in this Greenwich Associates’ study have increased their use of the funds in the past three years, and more than half of current users now hold at least four bond ETFs in their portfolios. Thirty percent of U.S. study participants have executed a single ETF bond trade of at least $50 million, including 14% of institutions that report completing a single trade of more than $100 million.
ETF allocations have grown to roughly 18% of total fixed-income assets among the institutions participating in the study. Study participants are increasing their use of bond ETFs for two primary reasons: 1) They provide enhanced portfolio liquidity with relatively low trading costs, and 2) because they are operationally simple, ETFs are easy to use in their portfolios.
With their versatility as a portfolio tool, institutions in the study are employing ETFs to obtain narrow and broad exposures in both high-level strategic functions and targeted, tactical applications. Institutions’ results with these investments to date are a positive indicator for future ETF growth in the channel. Ninety-nine percent of study participants that have invested in ETFs say they were satisfied with the experience, including such factors as pricing, market impact and time to execute, and 95% say they would trade ETFs again.