Fixed income assets have again delivered positive returns year-to date, albeit at a lower level than investors have become used to. We update our views and provide a checklist to help navigate returns. We are wary, but more strategically than tactically.
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Government bonds: too soon to call the breakout in yields
We do not think government bond yields are about to break dramatically higher. The bellwether US 10-year yield has pushed above 2% (again), but we are not convinced that it has much further to rise just yet. Inflation as measured by the core personal consumption deflator – the Fed’s preferred indicator – is trading close to 1% and expectations have fallen. With growth likely to slow in the second quarter, we doubt the Fed will taper its QE imminently, and higher short rates are still many months away.
In Europe, core yields have remained fairly stable year-to-date, compared to their US counterparts. As expected, Spanish and Italian bonds have helped the wider indices outperform, because they trade as ‘risk-on’ assets. Their yields are back down at around 4% and could even move lower still if investors believe strongly enough in the ‘Draghi put’, i.e. that the European Central Bank will ride to the rescue of the bond market should the region’s crisis worsen. We prefer to take peripheral eurozone exposure through corporate bonds (see below). Meanwhile, the Bank of England is sounding less downbeat about growth, as noted above, but the data needs to firm up more before UK yields trade sustainably higher. Overall, rangebound trading for global government bond markets is likely for now. Further ahead of course we continue to expect a structural rise in yields on a multi-year view, as the global economy and markets slowly normalise.
Investment grade: ticking along at expensive levels
Financials have led investment grade returns, particularly in the subordinated space. The changing regulatory environment makes it one of the most dynamic fixed income sectors. We remain overweight lower tier 2 debt of selected banks but have reduced our allocation to insurers which have rallied to fair value, in our view.
Figure 1: Global valuation metrics for our fixed income asset classes
Figure 2: Investment grade spread differential by rating bucket
The six-notch downgrade of the UK’s Co-operative Bank in May reminds us that credit selection is crucial. BBB-rated issuer spreads have compressed but there is still value, particularly in industrials and utilities which have lagged the recent rally (Figure 2). We advocate a barbell approach with higher-rated corporates: the incremental loss of yield is now relatively small. We expect total returns of 2-3% this year, below what is needed to compensate for risk, and remain tactically as well as strategically underweight.
“Careful credit selection is paramount for investment grade credit”
High yield: carry on
Fundamentals here are still robust. Global default rates are currently 2.6%; Moody’s forecasts them to remain below 3% this year. An increase in issuance in ‘covenant-lite’ and payment-in-kind notes hints at a deterioration in credit quality but, to date, volumes are small and unsurprising. The majority of debt issuance is still for refinancing. Average credit quality remains high and leverage low relative to historic levels. With the majority of the index trading above its call price, there is little room for further capital appreciation and it is probably too late for new allocations to this asset class. The carry still looks attractive, but our expected total returns in the region of 5.5-6.5% for 2013 imply some fall in price from here. Europe continues to look more favourable than the US, albeit by a smaller margin. Credit selection is key: we favour funds, or UK retailers and peripheral industrials that have demonstrated solid cash flow.
Emerging markets: spread picking
Emerging market (EM) fundamentals look appealing: growth is subdued and inflation is under control – yields could move lower. Flows into EM should continue to remain positive as investors hunt for yield, though the pace is likely to ease. The majority of our hard currency benchmark is government related (74%), which underperformed throughout April: we prefer corporates. With a stronger dollar and some central banks trying to weaken their currencies, enthusiasm for local currency bonds has waned. Interest rates in this space may be appealing but investors need to be aware of FX risk.
Figure 3: Fixed income checklist – allocations in a balanced (multi-asset) portfolio