Yield differentials favour high-yield corporate bonds
As central banks have brought forward easing plans, investors have rushed to sovereign bonds, pushing yields to historic lows, but 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. The Federal Reserve (Fed) signalled a shift to easier policy in late 2018 and duly followed through in July with the first rate cut in almost 11 years. More are expected and, with heightened trade tensions weighing on business and investor confidence, yields on longer-dated US Treasuries (UST) have lurched towards their 2016 lows. In such phases of buying panic, lower yields still cannot be ruled out. However, with 10-year yields now negative after inflation, UST offer little long-term value.
Eurozone. The rush to buy long-dated bonds has pushed 10-year bund yields well below the ECB’s negative deposit rate – indeed, all German government bonds now trade with negative yields-to-maturity (YTM). In addition, spreads between euro zone periphery bonds and bunds have widened modestly as investors have balked at chasing Spanish and Portuguese yields into negative territory. As with UST, there are few pockets of value in euro zone government bonds although the impending dovish shift from the ECB should keep a cap on yields.
UK. As the UK government moves to suspend parliament in order to complete Brexit by the October 31 deadline, uncertainty has skyrocketed and investors have begun to factor in rate cuts from November this year. 10-year UK Gilt yields have followed US and European yields ever lower and now offer less than 50bps YTM. However, Brexit-induced sterling weakness should put upward pressure on inflation, a long-term negative for such low-yielding bonds. In the near term however, buying pressure is strong, keeping yields low.
US. Growth and trade war concerns pushed corporate bond (credit) spreads wider in early August but they have recovered somewhat since. Higher-quality investment grade (IG) and lower-quality high yield (HY) spreads are now close to the average over the past 12 months. As indicated in previous comments, the current context makes it difficult for spreads to tighten much but the carry remains appealing, especially on HY issues, which offer a reasonable real return – about 200 basis points above inflation – a novelty in fixed income markets.
Eurozone. With the ECB expected to resume asset purchases, IG credit spreads should remain at tight levels. Negative government bond yields and shrinking bund issuance mean that more room may be made for corporate securities purchases. With Germany close to recession and hard Brexit risks rising, it is unlikely that HY spreads will tighten much – however, attractive carry means decent return potential.
UK. Government yields continue to plummet as the uncertainty around Brexit grows. Credit spreads have risen well above those in the euro zone, and indeed the US, but weaker domestic activity and falling business confidence have conspired to weaken appetite for sterling credit.
With global trade slowing and heightened trade war concerns, emerging market (EM) currencies have plumbed new depths. EM credit spreads have risen in sympathy, hitting the highest level since early 2016. While there are idiosyncratic problems in Argentina or Turkey, overall macro imbalances have improved, meaning better credit quality. However, unlocking this value may take time and EM currencies will remain a critical factor to return.
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.