Attractive carry from high-yield corporate and EM bonds
Within fixed income markets, sovereign bonds offer little value, with some exceptions such as emerging markets (EM). Corporate credit continues to offer more potential, especially in risk-adjusted terms. Our preference goes to high-yielding bonds, thanks to the attractive carry available.
UK. With global central banks embarked on a concerted round of easing – and Brexit uncertainty set to remain high – the Bank of England is unlikely to tighten any time soon, despite inflationary pressures. Still, gilt yields remain sharply negative after inflation and offer negligible long-term value. Moreover, the new cabinet’s spending plans are likely to increase government borrowing, meaning more gilt issuance. However, once again, political risk appears to have the effect of bringing gilt yields lower, as does volatility in equity markets; this is precisely why we continue to hold them.
US. The Fed implemented its second rate cut of this cycle in September and investors expect more to follow over coming quarters, given the macro and geopolitical headwinds. Moreover, recent money-market tensions suggest the Fed may resume asset purchases in coming months. Nonetheless, we continue to judge that fears of recession are overblown, leaving longer-dated US Treasuries (UST) at the potential risk of a sell-off. In balanced mandates, we continue to hold them primarily to diversify against equity risk. Moreover, the yields in the bond market has continued to humble many with its ability to test new lows.
Eurozone. The ECB delivered a raft of easing measures in September in the face of decelerating industrial output, most worryingly in Germany which faces recession risk. While further easing is still possible, the ECB preferred to call on governments to play their part via fiscal policy – and there are signs that the subject is no longer taboo in capitals like The Hague and Berlin. Core government bonds offer sharply negative nominal yields and remain unattractive.
UK. The UK economy has slowed more than its neighbours and Brexit uncertainty has led investors to shy away from UK credit, keeping spreads well above those in euros or dollars. This is only likely to change once more clarity has emerged about the UK’s future trade status with the European Union, which is unlikely in coming months. Until then, we suggest a cautious stance, particularly on Investment grade (IG) issues.
US. IG corporate credit spreads have tightened a bit further since late August as UST yields have risen. High Yield (HY) bonds look more attractive today – spreads are at fair value but the current yield pick-up (“carry”) should translate into stronger returns going forward, especially as attack-induced upward pressure on oil prices should help the energy sector, a sizeable HY issuer.
Eurozone. IG spreads have tightened significantly in anticipation of ECB buying and no longer offer much value as credit quality in less robust issuers looks stretched. Moreover, much of the segment trades with a negative yield today. As a result, HY bonds continue to hold our preference – they continue to attract yield-hungry investors and still offer an attractive source of carry.
Emerging economies have improved economic governance – via central bank independence, free-floating currencies and reduced current account deficits in many cases – and inflation levels are under control. Macro news-flow remains worrying, especially as regards the US-China trade war, but with global investors hungry for yield and many EM central banks following the Fed’s lead on policy-easing, the 300bp spreads available on hard-currency sovereigns still look attractive.
While government bonds offer poor value in absolute terms, the normalization of bond yields has ended with most yields collapsing to record 2016 lows again in 2019. 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.
It is unlikely that HY spreads will tighten much – however, attractive carry means decent return potential. We remain Strong Overweight.
Emerging debt (in $)
EM credit spreads have risen as global economy has slowed, hitting the highest level since early 2016. However, overall macro imbalances have improved meaning better credit quality.
Source: Kleinwort Hambros 04/09/2019
*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.