Despite the current trade tensions, and the issues in Italy, there are enough positives to put us in the pro-risk camp and put bond investors firmly in a bind – unsure whether to switch out of conventional bonds and into other, more suitable assets, or sit tight and hope for the best.
If you are going to hold conventional bonds, you have to believe economic conditions won’t improve; deflation will set in and central banks will keep trying to drive yields lower – an unlikely prospect in our view at Lyxor. The market tends to agree – year-to-date returns are negative for the first time in a decade. There are, however, ways to stay in bonds, but mitigate the damage. Here are five things our experts believe you could do with your fixed income portfolio in Q4:
Soften the blow in the US
Solid growth and ongoing rate hikes have pushed 10-year Treasury yields above 3.10%, the highest level since 2011. They could reach 3.4%+ over the next 12 months, driven on by inflation and growing term premia (i.e. the extra return demanded by bondholders to prefer long maturities to shorter ones) as the Fed’s balance sheet shrinks further. Risks include above-trend growth, higher inflation, and lower demand. Rate hikes could yet accelerate.
At the very least, we’d suggest holding some short-dated assets maturities, but we’d go further by looking towards inflation-linked bonds and floating rate bonds to hedge against inflation surprises and rising yields.
Be selective in Europe
After a 0.75% high earlier this year, 10-year bund yields have eased lower on softer growth data in core EMU, the political crisis in Italy, and muted inflationary pressure. The ECB has committed to delay hikes until summer 2019 – we expect the first just prior to Mario Draghi’s retirement in October. For all that, the rupture with Rome can’t conceal signs of greater economic stability in the eurozone, so we still expect long-term yields to rise on bellwethers like the bund as ECB purchases fade. We prefer short maturity bonds. In the UK, Brexit-related uncertainty leaves us neutral at best on gilts.
The EC’s rejection of the Italian government’s first draft of its new budget will pile more stress onto BTPs, and give some short-lived support to core European bonds. But these bonds are already overvalued and an amicable resolution may well be reached in time – reality will still set in. We favour peripheral bonds, including BTPs, over the long run as they come with carry. The wary might consider giving Italy a wide berth, but being brave and buying the dip might prove more rewarding.
Favour European breakevens over their US peers
Oil base effects should weigh on headline inflation in the short term, so we are neutral on eurozone inflation-linkers. We prefer inflation breakevens given the ECB’s intention to normalise policy, rather than be too fearful of the inflation risks. Breakevens have already been supported by oil price rises and higher nominal yields but linkers face the twin challenges of dwindling supply (particularly from France and Germany) and, crucially, dwindling demand from the ECB. Expect the approach of the ECB’s tightening cycle to add further momentum.
Take a little credit
Credit returns may have been fairly disappointing this year, but we still prefer it to government bonds. This is no carte blanche call, however. It’s time to exercise some caution and selectivity now that the catalysts for US high yield (the major bright spot in 2018) have waned somewhat. In the eurozone however, high yield bonds should outperform their investment-grade counterparts thanks to tight supply, decent earnings growth and the more stable economic backdrop – which should keep defaults low and conventional bond yields even lower.
Add some hard currency EM debt
Emerging market sovereign bond spreads have widened significantly since the beginning of the year but outflows have been contained by improved fundamentals and the limited risk of a sharp slowdown in Chinese activity. Looking ahead, EM sovereign debt should benefit from a softer US dollar and the lesser pace of Fed hikes in 2019. Higher oil prices could support issuers such as Mexico, Indonesia, Russia and Colombia. Hard currency EM credit spreads look attractive and have plenty of room to narrow.
* Before deciding to use Short & Leveraged ETFs, there are some things you should know. Leveraged products amplify both gains and losses by a given leverage factor. Losses can therefore be substantial. The performance of single short, double short and leveraged ETFs is calculated on a daily basis. This means there is a compounding effect as the daily return will always be based on the previous day's closing price. Compounding can lead to slippage over time between the index and the ETF. This slippage can be significant over periods longer than 1 business day, meaning these ETFs are typically unsuitable for investors planning to hold them for longer than one trading session unless used as part of a trading or hedging strategy. Any positions in these ETFs should be monitored on an ongoing basis. We recommend investors carefully read the 'risk factor' section of the product's prospectus and Key Investor Information Document (KIID), available for download on www.lyxoretf.com
Source: Lyxor’s Cross Asset Research team. All views & opinion as at 11 October 2018 unless otherwise stated. Past performance is no guide to future returns.
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