Muted inflation and dovish central banks have kept a lid on long-term yields so far. However, we continue to recommend short maturity sovereign bonds as risks are tilted towards higher yields. In the US, the gap between short and long-term yields is barely positive and Bunds look expensive, especially after the recent rally.
We recommend short maturity sovereign bonds
Prefer short-dated bonds. Since early 2019, yields on 10-year US Treasuries have traded in a narrow range between 2.55% and 2.80%. The minutes from the Federal Reserve (Fed) January meeting outlined a patient approach to monetary policy given the uncertain outlook. We nevertheless expect US 10-year yields to creep up towards 3.00% as growth remains sustained and market measures of inflation expectations (“break-evens”) are rising. We still prefer short-dated bonds which offer almost the same yields as 10-year bonds but with far less interest rate risk.
Bund valuations are expensive after the recent rally. In the eurozone, core bond yields have been pushed lower by weak macro data, lingering political risks and a scarcity of high quality liquid assets. The 10-year Bund yield is hovering around 10bps, the lowest since late 2016, but we think it is unlikely to fall much further. At current levels, yields are unattractive and bonds overly sensitive to rate moves. However, there is perhaps better value in peripheral bonds – the risk-reward is attractive in a low interest rate environment.
UK Brexit risk lingers. We still hold sovereign bonds (“gilts”) for diversification, particularly as the probability of a no-deal Brexit is relatively low. The Bank of England (BoE) should keep interest rates on hold given the slide in growth momentum, which should support gilt valuations.
Constructive view on corporate bonds
Still prefer US HY. The yield differential (or “spread”) between Treasuries and US corporate bonds (“credit”) has narrowed thanks to higher oil prices and solid macro data. Default rates are expected to stay below historical averages and stable corporate bond issuance bodes well for US HY. Based on our Fed policy projections and spread forecasts, HY remains attractive relative to Investment Grade (IG) – HY delivers an extra 300bps of yield at current levels. We believe corporate credit is appealing – recession risk remains remote and corporates have been able to lock in attractive borrowing rates over the past few years.
EMU HY increasingly attractive. In the eurozone, spreads widened steadily in 2018 as investors demanded better compensation for credit risk. HY spreads more than doubled and now offer an opportunity to rebuild positions. Despite ending Quantitative Easing (QE), the European Central Bank (ECB) seems keen to support credit growth, which should help keep default risk in check this year. The hunt for yield will encourage investors to prefer corporate bonds to sovereigns.
Brexit uncertainty will continue to weigh. We maintain a defensive stance on UK credit despite attractive valuations. Brexit uncertainty should continue to weigh on corporates in the short run, keeping spreads relatively high and volatile.
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