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Hunting for Yield In the Fixed Income Markets

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Bond returns have again exceeded expectations this year, but things could be changing. Yields are drifting higher, central banks are a little less cautious and inflation could be on the mend. What’s next for yield hunters?

Government bonds

US treasury yields set to rise

Inflation may still be below its 2% target, but it’s likely to be nearer 3% by year end. With the economy in good shape, the Fed has a one-way ticket to normalisation – only another major economic crisis would make it turn back.

Yields of below 2.5% on 10-year notes suggest the market still hasn’t fully woken up to the Fed’s plans. We expect another rate hike in December, and believe 10-year yields could rise to 2.5% within three months (and continue widening gradually afterwards). Don’t be too underweight Treasuries just yet – they are still a safe haven asset, and they are one of the few to come with reasonable carry. 

Outlook mixed in eurozone

The ECB taper looks imminent, although with the dovish Draghi at its helm and the inflation target of 2% seemingly out of reach for now, we believe it will only be gradual. Eurozone sovereign yields seem likely to follow US treasury higher by contagion in the short term. There could be opportunities to play bunds tactically into year-end but we favour French OATs. Structural reforms and new-found budget rigour could prompt a rating outlook upgrade very soon.

In general though, return-seekers could find sovereign bond spread returns too tight and volatile to be of any great interest.

Playing the periphery

Peripheral spreads have proven remarkably resilient. At Lyxor, we have favoured Spanish bonds but the unrest in Catalonia has us reviewing that position. Italian government bonds should provide some carry, and possibly even tighten in the near term.

Neutral on JGBs and UK gilts

The Bank of Japan is in no rush to tighten its hold. The bank remains intent on anchoring ten-year Japanese government bond yields at 0%, so we’re neutral on the asset class. The Bank of England, for its part, is keen to tighten but Brexit means it has little option but to proceed with caution. We’re neutral on gilts, but prefer them to bunds both from a carry and interest rate perspective.

Credit  

A positive short-term outlook for credit...

The credit markets seem on solid footing for now. Valuations are on the rich side, but fundamentals still look good. Some investors fear European markets would become more vulnerable should the ECB start tapering its corporate sector purchase programme, but we think not yet. Much of the tapering is already priced in – and credit will be far from first on the list.

...but stay on your guard

Investors may need to reconsider their positions soon.   Overbought markets, rising rate volatility and central bank misjudgements are all possible reasons for caution. The price of oil could also become a factor (especially in the US), as could politics – despite the latter’s surprisingly limited impact so far.

High yield: an option for optimists

US high yield remains an option, provided we don’t see the kind of sovereign yield spike that could strangle its appeal. We still favour European high yield, but acknowledge it looks expensive, with spreads historically tight. However, we see limited risks of a reversal, and so retain our slight overweight.

Emerging markets

Emerging debt to continue its rise...

Emerging bonds have performed very well so far this year, and we expect further positive, carry-fuelled, returns for hard currency sovereigns – albeit not as impressive as they have been as headwinds pick up in intensity. Local currency debt comes with FX risks that make us uncomfortable, especially as the Fed is removing accommodation.

...but credit looks expensive

Rising rate expectations on both sides of the Atlantic are pressuring hard-currency markets, and emerging credit spreads could widen in turn. What’s more, emerging corporates remain pricy – corporate spreads are more or less in line with sovereign spreads.

Finding the sweet spot

Targeting specific yield opportunities may be more rewarding than banking on all bonds over the coming months. In Lyxor’s view:

  • Sovereign bonds from three European countries look to be of particular interest:

  1. Spain – the economy is recovering, carry is considerable and we see little risk of disruption, even if the ECB tapers. Keep a watchful eye on events in Catalonia.
  2. France - a rating upgrade looks imminent. Its sovereigns provide less carry than those on the periphery; but they’re a better option than bunds for an ultra-safe hold.
  3. UK - growth and inflation data should keep the BoE on hold and yields stable for a while yet.

  • Away from Europe, treasuries look a solid option for pessimists. A yield of over 2% could see them well rewarded.

  • For the optimists, we see two good options: emerging debt and European high yield. We believe the ECB will extend its programme through 2018, and will pay particular attention to the last segment (corporate bonds) it touched, keeping high-yield credit safe. The emerging debt story rests on much-improved domestic creditworthiness, but investors should note the downside risk.

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All opinions/data sourced from Lyxor & SG Cross Asset Research teams. Opinions expressed are as at 03 October 2017.

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