2019 saw a bond bonanza but fixed income allocations are likely to be more neutral this year, finds Nick Fitzpatrick.
After years of frustration at low yields, bond investors finally got some respite in 2019.
Unexpectedly, dramatic returns occurred. Ludovic Colin, a fixed income manager at Vontobel Asset Management, said some fixed income assets, issued by banks and known as AT1s, were up by 30% on a total return basis.
Much of this turnaround in bond markets centred on the Federal Reserve, which in July cut interest rates for the first time in a decade. The European Central Bank (ECB) also eased later in the year. Government bond yields fell and prices increased, allowing investors to make money selling them. With their cash, bond investors moved higher up the risk curve to investment grade and high yield.
The result was bond funds posting their second full-year inflow record in three years, notes Cameron Brandt, a fund flow expert at EPFR Global. He puts much of this down to investors preserving gains from equity markets.
Colin, who runs Vontobel’s multibond portfolio and is the Swiss firm’s head of global flexible investment, has a different take: “To enhance income and make a return, there was no alternative but to get out of government bonds in developed markets and go into corporate investment grade and high yield bonds, or to look at emerging market economies and corporates,” he says.
Christian Hantel, a senior portfolio manager who works with Colin at Vontobel, says: “Corporate bonds are usually the first step for people when they take more risk and get out of sovereigns. Also, there was clarity from central banks that there would not be more rate rises. Rate rises would have caused price depreciation.”
Investment grade US corporate debt returned 14.5% in 2019 and US high yield debt returned 14.3%, according to Barclays Bloomberg index total return data, which includes bond prices and interest payments. US Treasuries also had a good year, with a 7% return.
An increasing amount of government bonds were paying negative yields – meaning interest rate payments would add up to less than the bond price, once all payments ceased at maturity. Negative-yielding bonds from the likes of Germany and elsewhere totalled $13 trillion at one point.
In the first few weeks of 2020, bond markets were still reverberating from the energy that central banks had unleashed.
“Right now, you could reach your return target in three weeks,” says Colin, speaking on January 23. “I bet some paper in December and I’m already selling it now.” This is a reference to the AT1 bonds – higher yield convertible bonds issued by European banks. AT1s have benefited from a significant reduction in risk in Europe’s financial sector and pay one of the highest coupons in Europe’s fixed income markets, he says.
Yet he concurs with other commentators that the exuberance surrounding bond markets is not expected to last through 2020. Bond allocation is always quite complex, but is even more so now, he says.
Although bonds unexpectedly performed strongly last year, equities performed even better and the house view at Aviva Investors is that equity markets would outperform again in 2019.
The firm has increased equity investments and stayed neutral on bonds, saying that following a significant year for developed market bond yields, the risk/return trade-off in being overweight government bonds had deteriorated.
“Neutral allocations to fixed income – government and corporate – are justified by the tension between the growth recovery but low inflation and accommodative central banks,” Michael Grady, Aviva Investors’ head of investment strategy and chief economist, wrote in a 2020 outlook paper.
Central bank monetary policy and trade wars drove markets in 2019. If inflation is low, central banks will not likely put up interest rates. Nearly every central bank is now holding or cutting rates – a factor in why some fund managers like Aviva Investors have revised growth projections upwards for 2020. Equity fund managers hope growth will translate into company profits and lift equities - potentially to higher returns than last year.
All this is very different from what investors were expecting in 2019. Last April, for example, more than 80% of insurance company investors surveyed by Goldman Sachs Asset Management believed the US economy would enter a recession in 2020 or 2021.
Then in June, a Bank of America Merrill Lynch survey showed that fund managers investing money for insurers and other investors were at their most bearish since the global financial crisis, with cash allocations increasing and allocation to riskier assets at a low.
Everything seemed to change with the Fed rate cut in the summer; then in September, the ECB also cut interest rates and approved a new round of bond purchases to help Eurozone growth.
“Last year was exceptional for total returns,” says Colin Purdie, chief investment officer for credit at Aviva Investors. But he says more caution will be needed for corporate bond returns this year and highlights that valuations look “historically rich”, driven by the ECB’s corporate bond purchases, which are of some €20 billion a month.
All three fund managers – Colin and Hantel at Vontobel, and Purdie at Aviva Investors - say fixed income investors will have to work harder to identify areas of value in 2020.
Speaking about what they are wary of, Vontobel’s Colin says he is avoiding short duration bonds, which he says are giving people a “false idea of safety”, while Purdie says there are still some fundamental problems with European retailers and autos and warns that the ECB bond-purchasing programme will not save investors who own bonds that default.
What is interesting about Colin’s comments on short-duration bonds is that short-duration fund launches have been a notable part of the fund-launch landscape. They have been sold as a hedge against central bank rate increases, which were expected as part of monetary policy normalisation (see table for flow data).
Last year’s rate cuts showed normalisation was not yet happening. Colin says some short duration last year “got destroyed” and that duration in his multibond fund is three to five years, which he describes as neutral.
Speaking about what they may favour, Colin reiterates an appetite for emerging market bonds denominated in US dollars. Although he says the high coupons from these bonds are “too high compared to the fundamental quality of these countries”, the asset class could nevertheless be one of the best-performing bond markets of the year.
Asked about local currency emerging market bonds, Colin adds these will be a “tremendous” asset class – but a secular weakening of the US dollar needs to happen first.
Closer to home, Colin gives a nod to developed market government bonds, saying that the 60bps yield from Gilts “is not a bad return in an economy that’s not going to grow much for the next five years”.
As a credit manager, his colleague Hantel indicates he’s looking at corporate bonds with strengthening credit profiles. Using the lingo of the asset class, Hantel says “rising stars” are outpacing “fallen angels” due to credit-rating upgrades.
Aviva Investors’ Purdie indicates the firm is selecting from a menu of, among others, investment banking names because risk has reduced in the sector as banks have tailed back some of their operations. He also says he is “slightly more positive” on emerging market corporate debt because the sector is exposed to growth and will benefit from a reduction in US-China trade tensions.
Back to normal
The picture emerging is that, after a welcome bounce last year when bonds made a lot of money, business as usual is returning to bond markets this year. Investors will continue to search for yield and fund managers will use careful bond selection from the variety of bonds available to them, which has grown significantly over the past decade.
“Investors certainly got some respite last year,” agrees Erinn King, a managing principal and fixed income specialist at Payden & Rygel, But she adds: “With low rates and tighter spreads, the opportunity set for similar returns is more challenging this year.”
King is based in Boston but is also involved with Payden & Rygel’s European institutional investors, including insurance companies. European insurers are one segment of investors to be hit hard by low-yielding government bonds because the EU’s Solvency II regulations direct them into low-risk assets, both for regulatory solvency purposes and because lower-risk assets have less punitive capital charges.
Yet low yields have forced insurers to consider less liquid fixed income replacements, meaning assets such as real estate, securitisations and private debt. A survey published in November by Natixis Investment Managers showed that three-quarters of 200 chief investment officers at insurance companies said they were struggling to make returns and nearly 70% said alternative investments were “essential” due to the low-yield environment since the financial crisis. Private debt and real assets were wished for - but 97% of the CIOs said regulations were stopping them from investing in such higher-risk, illiquid assets.
King notes that some insurers are “giving up liquidity for higher potential yield and return”, though regulations place caps on how much of this is possible. “Insurers have to make good on their promises, which is first and foremost paying claims, so there is only so much they can do with illiquid instruments.”
She points out that following a relaxation of rules, Solvency II now gives securitisations that are deemed by the regulator as “simple and transparent” a capital charge similar to corporate bonds.
King adds: “At this point in the cycle, where we do not think a recession is imminent but we are clearly mid to late in the cycle, the securitisation segment offers some diversification benefits and structural protections. Corporate bonds are trading at very tight spreads and exhibit higher intra-sector correlations, but in the securitised market - especially in the US - there are more diversification opportunities, and although there is still the stigma of 2008 tied to the problems that emanated for the securitised market, a lot of the new structures are not the same as those back then.”
Along with more transparency, the level of subordination is much improved, says King, adding that Payden uses securitised bonds across multi-sector portfolios where possible.
Like other managers Funds Europe spoke to, King flags US dollar-based emerging market debt and says insurers are actively searching for this asset class: “Triple-B emerging market corporates yield 70-90 basis points more than US triple-B – yet they have the same capital charge.” But she says Payden is seeing currency-hedged US corporate bond mandates from European insurers. “Hedging costs have moved lower for euro to dollar and there is a depth and attractiveness of the US market, even though spreads are tighter.”
Two last points…
The trend among fund houses in their market forecasts at the start of the year has been to advocate more caution in bonds. The broad expectation is of an improving environment, but still with low economic growth, low inflation and – most influentially - accommodative monetary policy. So finally, two more observations on bonds.
Alasdair Ross, regional head of investment grade credit at Columbia Threadneedle, says this macro environment is supportive for investment grade bonds. Corporate earnings are strong enough for the moderate leverage in the asset class and investors searching for high-quality yield will support bond prices.
Unigestion’s cross-asset team noted in January that after the market euphoria of the fourth quarter last year, January sentiment was shifting to prudence. Although US equities posted a slightly positive return during the month, US high yield spreads widened markedly, delivering negative returns.
High yield is treated as being more sensitive to a growth environment than investment grade.
Meanwhile, says Unigestion’s team, safe assets such as US government bonds delivered “recession-like” returns and outperformed growth-oriented assets. US bond yields declined by 40bps back to August 2019 levels of 1.51%. The driver for this was “a fall in both main risk premia: growth and inflation”. Similar though softer trends were seen in German, Australian, Canadian and British government yields.
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