Still room for credit
While government bonds offer poor value in absolute terms, the drift in yields upwards has lost its thrust across most major markets, and they continue to be critical in offsetting risks from equities in multi-asset portfolios. For yield, we prefer riskier borrowers such as Emerging Market (EM) sovereigns and High-Yield (HY) corporates than investment-grade corporates (IG).
US. From their highs last autumn at over 3.2%, 10-year US Treasury yields have tumbled to well below 2.0%. Inflationary pressures have abated, and monetary policy is being eased, again. However, further falls in rates seem unlikely from these low levels. We expect headline inflation to strengthen towards yearend given the low base effect after Q4 2018’s slide in energy prices. Hence, we see modest upside in yields over the next twelve months and suggest intermediate maturities where expected returns should be positive.
Eurozone. Ten-year German Bund yields are at all-time lows, trading below -0.5%, far below the Eurozone’s July inflation rate of 1.1%. This forms part of over $15 trillion in government debt yielding below-zero at present. Investors are clearly willing to pay out of their pockets for the privilege of lending to the German government – it speaks to their pessimism of the future in the
UK. Fears of a hard “Brexit” have soared, keeping downward pressure on Sterling. This in turn has kept UK inflation expectations over 150bps higher than in the US. Despite this, tenyear Gilt yields have followed European rates down, hitting a record low of 0.52%. Thirty-year Gilts yield just 1.2%, well below the rate of inflation. Asset/liability guidelines for UK insurers and pension plans ensure continued high demand, and investors have judged that Brexit uncertainties will prevent the Bank of England from tightening policy.
US. The rather benign macro environment has proved rather supportive for corporate bonds and yield differentials (spreads) over sovereign bonds have narrowed markedly year-to-date.
From today’s levels, spreads are unlikely to tighten much further but the additional yield pick-up (carry) remains attractive, especially for higher-yielding (HY), lower-quality bonds.
Eurozone. As in the US, euro zone credit has registered strong performance so far this year. Balance-sheet quality is generally better than in the US but spreads are also much narrower. We
believe there is little likelihood of an imminent spike in the risk
of default. As in the US, our preference is for HY over higherquality, investment grade (IG) credit.
UK. Given high uncertainty surrounding Brexit, spreads have remained higher in sterling credit, especially for HY issuers. Such companies tend to be smaller than IG issuers and more vulnerable in the event of a disruptive no-deal outcome. As a result, carry looks very attractive but we would caution that a rally is unlikely until we have greater clarity on Brexit.
We continue to hold emerging market (EM) sovereign bonds. Trade war concerns and slower growth have kept spreads high despite the improvement in macro fundamentals and the hard
tilt in dovishness from developed market central banks. Moreover, we expect Chinese stimulus to support growth in the second half. There is still potential for spreads to tighten as yield-seeking investors return to this segment.
While government bonds offer poor value in absolute terms, the drift in yields upwards has lost its thrust across most major markets, and they continue to be critical in offsetting risks from equities in multi-asset portfolios.
We have a medium duration position across most portfolios.
Accommodative financial conditions, low inflation and steady growth are supportive, but spreads are tight and absolute yields are low. We prefer yield pick up further down the risk spectrum.
The yield pick-up offered by High -Yield corporate bonds remains attractive, especially as default rates are expected to remain low.
Emerging debt (in $)
Given the more favourable macro backdrop – a US rate hike cycle has reversed and Chinese stimulus will likely support growth – we see room for further narrowing of emerging yield spreads.
Source: Kleinwort Hambros 07/08/2019
*Duration: short = Up to 5 years, medium = 5-7 years, long = 7+ years
Past performance should not be seen as an indication of future performance. Investments may be subject to market fluctuations, and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk and you may not get back the amount you invest.