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Hunting for Yield In the Fixed Income Markets

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After some pessimism about the outlook for fixed income early in 2017, things are looking a little less worrying. Not for the first time, bonds are exceeding expectations.

For the bond bears to be proven right, however, we need more than good data. We need a significant shift in positioning, some hints that inflation (wage-related in particular) is on the mend, and less central bank caution. All this is still possible. And the markets are more fragile than they might otherwise appear. So, what’s next for yield hunters?

Government bonds

Outlook mixed in eurozone

The European Central Bank (ECB) is extremely wary of choking off the recovery. Stubbornly weak inflation and encouraging economic growth support tighter sovereign spreads over the medium term. That said, beware further volatility in the wake of ECB pronouncements. The euro’s run of strength against the US dollar is also worth watching.

Playing the periphery

Peripheral spreads have recently proven remarkably resilient. At Lyxor, we like Spanish bonds in the main, but Italian government bonds should also provide some carry, and possibly even tighten in the near term.

Overweight gilts

A gradual worsening of UK economic data following the Brexit vote, and political uncertainty since June, suggest the Bank of England (BoE) will stay on the side of the doves. With this in mind, we still like gilts.

Mind your head

Trump’s surprise deal with the Democrats kicks the debt ceiling can down the road to December, but we could still see a shutdown akin to 2013. Government bond markets tend to rally at times when investors seek out safe havens. Don’t be too underweight Treasuries just yet. They are one of very few assets to combine safe haven characteristics and some reasonable carry.

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. Much of the tapering is already priced in – and credit will be far from first on the list.

...but stay on your guard

Taking on credit risk seems fine for now, but investors may need to reconsider their positions later this year. As we write, overbought markets, rising rate volatility, and a higher VIX 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

For optimists, European high yield could still appeal. That said, were government bond yields to move much higher, it could choke off demand for riskier issues. Spreads could widen sharply in such a scenario.

Emerging markets

Emerging debt to continue its rise...

Emerging bonds have performed very well so far this year, and we expect further positive returns – albeit not as impressive as they have been. Accommodative central bank policies should shore up yields for a bit longer, while the crawl towards normal in developed markets should reinforce flows into higher-yielding assets.

...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

Carefully targeting the best 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’s economy continues to recover while wage pressures and political risks are subdued. Carry is considerable and we see little risk of disruption, even if the ECB tapers. Keep a watchful eye on the Catalonia referendum.
    2. France’s rating will probably be upgraded. Its sovereigns provide less carry than those on the periphery; but they’re a better option than bunds for an ultra-safe hold.
    3. The UK’s growth and inflation data should keep the BoE on hold and yields stable.
  • Away from Europe, treasuries look the best option for pessimists. A yield of over 2% could see them well rewarded.
  • For the optimists, we see two decent options: emerging debt and European high yield. We believe the ECB will extend its programme, 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. However, inflows have been considerable, and exposure to the Fed is still crucial, so 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 23 August 2017.

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