To view a PDF of this report click here.
By Philip Moore
“The great bond bull market is not over,” announced Ariel Bezalel, London-based manager of the Jupiter Strategic Bond Fund, in early October. Not so long ago, that would have been regarded as a brave call given the widespread belief that an imminent increase in U.S. interest rates was as certain as death and taxes.
Today there is a strengthening conviction that the slowdown in China and growing deflationary pressures are likely to mean that U.S. rates remain lower for longer. “We think a rate rise is off the table for this year,” says Lloyd Harris, manager of the Old Mutual Global Investors Corporate Bond Fund. “I’m sure that the Fed would like to raise rates. But external pressures, such as weak Chinese data and the possibility of further yuan devaluations, mean that we’d have to see a material pickup in global growth expectations if rates are to rise any time soon.”
In October, federal funds futures were still pricing in a 30 percent chance of a rate rise this year. That suggests that there is still sufficient diversity of opinion about the outlook for U.S. rates to ensure that whichever way the Fed jumps at the next Federal Open Market Committee meeting, the market’s short-term response is likely to be volatile.
No 1994 Rerun
Even if rates do start to edge up in December, however, investors are certainly not expecting a rerun of 1994, when a shock rate rise in February sent 30-year Treasury yields skyward. Charlie Diebel, now head of rates strategy at Aviva Investors in London, was a prop trader at the time and remembers the great bond market crash of 1994 well. “The Fed’s rate hike was driven by the perception of an inflation threat that never materialized,” he says. “Today we’re in a structurally low growth environment, which makes it hard to see where any inflationary pressures will come from. We’re a long way from a 1994-type scenario.”
Matt Toms, head of public fixed income at Voya Investment Management in New York, agrees. “We have believed for some time that rates are unlikely to move aggressively higher,” he says. “And when rates eventually rise, they may do so with a hop or a skip, but not with a jump.” The result, say many fixed income strategists, is that government bond yields are likely to remain low for the foreseeable future. HSBC’s global head of rates strategy, Steven Major, recently forecast that ten-year U.S. Treasury yields, which dipped below 2 percent in October, have further to fall and are likely to reach 1.5 percent by the third quarter of 2016.
Major is forecasting even deeper falls for Bund yields, suggesting that the yield on the ten-year German government bond could decline from today’s level of a little over 0.5 percent to as low as 0.2 percent. That is well below the market consensus, which sees German government bond yields rising over the next 12 months as economic recovery in core Europe gathers momentum. A likely by-product, some investors say, will be a steepening of the European yield curve relative to the U.S. “I see opportunities for curve trades in 2016,” says Jon Jonsson, managing director and senior portfolio manager for global fixed-income strategies at Neuberger Berman in London. “I believe that the U.S. curve is too steep between 10s and 30s, while in Europe I see a steepening bias because Germany has better growth potential than is being priced into the market at this point. The German economy should benefit from low energy prices, the weak euro, less fiscal austerity and increased credit flows. So a long-term trade that I expect to use next year is to be long in 30-year U.S. Treasuries and short in Bunds at the same point on the curve. The spread between the two is currently 150 basis points [bps], which I think is too high a differential given the growth outlook in the U.S. and Germany. The relative nominal GDP implied is not sustainable in the long term.”
With government bond yields likely to remain low for the foreseeable future, the global hunt for yield will remain alive and kicking. This is restoring fixed-income investors’ appetite for credit in spite of concerns about diminished market-making capacity in the corporate bond market and its impact on liquidity. “It’s hard to see the yield on the ten-year U.S. Treasury building any momentum beyond 3 percent, so our base scenario is for a modest flattening of the curve. We think that in this environment it makes sense to give up some liquidity in exchange for increased income,” says Voya’s Toms.
Toms points to U.S. housing and commercial mortgage-backed securities (CMBSs) as asset classes that are now offering value for investors prepared to make this trade-off. Neuberger’s Jonsson is adopting a similar strategy. “We’re a buyer of some of the subprime debt issued between 2003 and 2006, which still offers attractive loss-adjusted yields of between 4 and 6 percent,” he says. “The housing market is recovering, the consumer is benefiting from low energy prices, and unemployment is falling, all of which is positive for the housing sector. These securities are no longer being issued, and they continue to be prepaid, so from a technical perspective they are very different from investmentgrade credit, where we are still seeing a lot of issuance.”
Improving Prospects for High Yield
Jonsson’s other favored asset class right now is U.S. and European high yield. “We went short in U.S. high yield last summer, when spreads were just over 300 bps, but we’ve been comfortable buying back into the market at spreads of between 550 and 600 bps,” he says. Assuming annual losses given default (LGD) of 3 percent, these levels still offer an appealing risk premium of 250 bps, Jonsson says. He concedes that these spreads could balloon to 1,000 bps in the event of a U.S. recession but says this is a highly unlikely near-term scenario.
Other investors add that the U.S. high-yield market would have little to fear from a gentle tightening in monetary policy. John Addeo, senior portfolio manager and deputy CIO for fixed income at Manulife Asset Management in Boston, says he sees value in the investment-grade and high-yield markets after this year’s spread widening. “There are a couple of factors that give us comfort in the high-yield market,” he says. “One is that the almost unfettered access that companies have had to capital over the past six years means that they have been able to reduce the cost of their debt quite considerably and to extend their overall maturity profiles.”
Addeo says: “The other factor is that if we were to see the sort of inflationary pressures that would lead to a rate increase, this would generally be perceived as positive for leveraged capital structures. This is because top-line growth and margin expansion would be supported while debt-servicing costs would generally be fixed. So unless we saw rates increasing to the point where they would stifle economic growth, we think the outlook for high yield is attractive.”
The Manulife portfolio manager is more cautious about the prospects for another high-yielding but unloved asset class: emerging-markets debt. This year’s capital flows to emerging markets will turn negative for the first time since 1988, according to projections from the Institute of International Finance (IIF), with equities and bonds both negatively affected by global institutional selling. “There is value in some areas of the emergingmarkets universe, but we remain cautious,” says Addeo, who regards active currency management as an important way of mitigating volatility and generating alpha over time.
Addeo’s careful approach to emerging-markets debt is shared by other investors. “It is still hard to be bullish on emerging markets, but we may start to see more differentiation among individual markets rather than the blanket selling we have seen to date,” says Voya’s Toms. This suggests that it may be increasingly worth keeping an eye on the likely winners and losers that will emerge from global trends such as low oil prices. Among the winners, says Neuberger Berman’s Jonsson, will be beneficiaries of lower commodity prices, such as India, which is already among the best-performing emerging-markets debt markets in 2015. He points out that current oil prices are shaving more than 4 percent off India’s annual import bill.
Maintaining exposure to a broad range of investment styles and sectors, strategists say, is ultimately the most efficient way for investors to protect themselves against shifts in monetary policy. “We think it is essential to avoid being a slave to duration risk, and the best way to do that is to explore the vast diversity of opportunities that are available across the $100 trillion global fixed-income market,” says Ahmed Talhaoui, managing director of fixed income at BlackRock in London. “Maintaining a very low level of interest rate sensitivity in our flagship unconstrained portfolio, if we want to, means that we don’t have to ask ourselves each morning if this is the day interest rates are going to rise. This is because we should be able to generate a positive risk-adjusted performance regardless of the rates environment.”
Lower for Longer — or Lower Forever?
Irrespective of when the Fed will pull its rates trigger, the general consensus is that bond yields are unlikely to return to previous cyclical peaks. Over the short term, supply-demand dynamics are expected to anchor bond yields at relatively low levels by historical standards. As the BlackRock Investment Institute noted in a recent update on the outlook for fixed-income returns following the Fed liftoff, long-end yields in the U.S. will be capped by “a shortage of supply of high-quality bonds, insatiable demand and lower yields in other developed countries.” More specifically, BlackRock explains that demand from regulated asset owners such as insurers, central banks, pension funds and banks, which have annual aggregate reinvestment needs of some $4.5 trillion, will outstrip the total global supply of highquality, liquid fixed income in 2015 and 2016.
BlackRock believes that in 2017 this supply-demand dynamic will reverse, with the net supply of sovereign bonds rising sharply as the European Central Bank and the Bank of Japan exit from their quantitative easing (QE) programs.
Whether this will be enough to push yields back to their precrisis levels is open to question. Andrew Milligan, chief strategist at Standard Life Investments in Edinburgh, says his team has decomposed U.S. yields into their three components (inflation, real short-term interest rates and the term premium) to assess their likely levels in a normal economic recovery. The conclusion of this analysis, he says, is that the U.S. ten-year yield is likely to peak at between 3 and 4 percent during this cycle—far below the 5.16 percent that was reached at the top of the previous cycle.
“Yields could go higher than this in an environment of high inflation, and a lot lower if a sharp slowdown in China leads to another global financial crisis,” Milligan says. “But our base scenario is that there are half a dozen structural drivers of lower long-term yields. These range from the regulation of fixedincome markets to pension fund demand, demographics and the conundrum of lower productivity, all of which will have an impact on long-term bond yields.”
Standard Life Investments’ analysis notes, “Unless politicians unexpectedly grasp the nettle and lift infrastructure spending considerably, as well as accelerate structural reforms, then we conclude that productivity growth—and hence the natural real rate of interest—will remain lower than its historical norms.”