Shaken or stirred, Mr Bond?

There are still lots of reasons not to be bearish on fixed income. However, the macro outlook does lend itself to the idea that somewhat higher yields would not be out of place. Indeed, yields in the US Treasury market have been trending higher for some time now. The end of a 40-year bull market in bonds does not necessarily mean that we are on the brink of a bear market. But it would be prudent to consider the idea that returns are going to be challenged in the months and quarters ahead. Yields are low and credit spreads are almost back to their pre-crisis lows. The prospective return is skinny and there might even be a period of negative returns. You don’t get them very often and markets may self-regulate any rise in yields (equities sell off?). However, you do get them now and again. If the Treasury 10-yr yield is heading above 1% then one might be just around the corner. 

Drama...

There’s already enough drama in commentaries about financial markets without me adding to it. However, some questions keep coming to mind when I think about the outlook for fixed income. What if the 40-year bull market in bonds is over? What if we have seen the lows in yields and that the QE-inspired era of strong bond returns is coming to an end? If it hasn’t, and fixed income can still deliver strong returns in the coming year, that necessarily has to mean credit spreads venturing towards new-post global financial crisis (GFC) lows and more and more debt trading with negative yields. It also means that there is so much excess global savings that investors will continue to pay governments for the privilege of lending them money. As global government debt and borrowing rises, the question is raised as to whether this can persist. 

... or pantomime?

The last decade is littered with comments calling the low in government bond yields. Yet, it turned out that zero need not be a floor for market yields and that zero needn’t be a floor for the cost to governments of borrowing from the private sector. Governments issue bonds with very low or zero coupons but with an issue price above par, which immediately gives a negative yield to maturity. Because of the strength of demand for high quality government bonds, investors buy them and take the price even higher making the yield to maturity even more negative. According to Bloomberg, the market value of bonds within the global aggregate index that has a negative yield is $16.7trn. The entire German government bond yield curve has a negative yield to maturity, as does the Dutch government curve, and the French curve out to 15-year maturities is negative yielding. Even Italian and Spanish debt out to 5-year and 8-year maturities respectively are negative yielding. Just a few years ago we were wondering whether these sovereign issuers would be able to continue to honour their sovereign euro denominated obligations. The bond market today provides loads of opportunities for investors to buy an asset with a guaranteed negative return. Just say that to yourself in a quiet, dark room. It’s quite mad really.

Slowly, slowly

Calling the low in yields is a dangerous game. However, putting forward the proposition that the return outlook for bonds is not encouraging has more merit. So far this year, the total return on the Bank of America US Treasury index has been 8.5%. That is both well above the long-term average and difficult to match when the average yield today is just 0.65%. To repeat that total return over the coming year, there would need to be something like a further 100bp decline in US Treasury yields. On the basis of the consensus economic outlook for 2021 (difficult start then post-vaccine boom) there is no real macro-economic justification for that to happen. Indeed, the market is moving the other way. The post-crisis low for the 10-year benchmark yield was 0.5% in August. Today, the yield is 0.93%. 

Strong hands

A lot has been done to support bond markets this year. Central banks credit and liquidity facilities have been super important. So have ongoing asset purchases. This has allowed yields to stay low even with lots of government borrowing. There will continue to be strong hands in the market – central banks themselves but also institutional investors that still face duration gaps in their insurance portfolios or pension schemes. However, prices are set at the margin and the more profit seeking players take the view that the economic environment does not need or justify lower yields, negative price momentum could take hold.

Awash with credit

Could we look to credit for positive returns if underlying rates are going to remain stable (or higher)? A risk-on view of life, which I think is appropriate going into 2021, would suggest that credit spreads can go lower. AXA Investment Managers’ fixed income teams uses a framework to assess the importance of various drivers of bond market performance including the macro outlook, valuations and investor sentiment. The other factor is “technical”. This has been a big influence on bond performance in recent years as a result of central bank asset purchases but also the general search for yield in a declining interest rate environment. In the credit markets there is likely to have been close to $2.5trn of newly issued US corporate investment grade and high yield bonds in 2020. In Europe the figure is likely to be above €300bn. This has all been bought with gusto. European credit spreads (asset swap on Bank of America European Corporate Bond Index) are just 10 basis points (bps) above where they were at the end of 2019 while the yield-to-worst is 23 bps lower. For the US market the equivalents are 9 bps wider credit spread and roughly 100 bps lower in yield. Considering a massive (if short-lived) global recession and rolling lock-downs for many businesses, it’s hard to explain the spread tightening and positive returns through the macro lens. The ‘technicals’ have been very strong. The demand for yield remains strong. Industry data suggests that flows into fixed income funds have been massive in recent months. And there are still pockets of yield. Asian sub-investment grade yields over 7%, the broad emerging market bond index yields 4.75% and the lowest rated parts of the US and European high yield markets can provide 10% yields to worst. 

High yields, higher risk

Of course, to get those yields and have a higher probability of positive returns, one is taking on more market risk and potential default risk. This is nothing new, it’s been a feature of the QE era and the opportunities exist today because we had a massive credit sell-off in March and not everything has recovered at the same rate. For good reason to. Issuers whose bonds pay these kind of yields are weaker companies, those that have likely been most hit by the pandemic and with the most leveraged balance sheets. But if the broader market is strong, an investment strategy that focusses on distressed and higher yielding debt can be rewarded. 

Thin pickings

More broadly the best outcome for fixed income in the months ahead is that government bond yields stay within established ranges and credit spreads grind lower. Before the global financial crisis, spreads were a lot lower than they are today. For example, on the Bank of America Global Corporate Bond (investment grade) index, the asset swap spread fell to 31bps in 2007. Today it is 109 bps. Yet the two periods aren’t really comparable. Back in 2007 the overall yield was above 5% compared to less than 1.5% today. Bonds are expensive because central banks have repressed borrowing costs globally. In 2008, the annual total return on that global index was -4.7%. There was more carry to protect from wider credit spreads – which moved from 31bps to 371bps in the space of a year as the credit crunch unfolded. A repeat of that is highly unlikely but there was more than 200bps widening in March this year. There is just less cushion from prevailing yields to protect against either a widening of credit spreads or a rise in underlying yields. 

Curve #1

Key to all of this is the Treasury market and the potential for the yield curve to steepen. The curve has been steepening for over a year now. Further steepening, with policy rates unchanged through 2021, will need to be driven by the macro-cycle. When I compare the US to the Japanese yield curve, it is fairly obvious to see the job the Bank of Japan has done in keeping the curve flat through its yield curve control policies. An approach such as this remains an option for the Fed, but the US is different. The delta on GDP growth and on government borrowing is likely to be larger than has been or is likely to be the case in Japan. My own expectation is that we will get one of two scenarios. The first, a bit of shake for Mr Bond market.  The bias is for the curve to steepen and 10-year yields to keep pushing towards and maybe above 1% and to the 1.25% range, to come back down again in a saw-tooth kind of pattern. Choppy economic data for the next six months and the realisation of the magnitude of the task of vaccinating hundreds of millions of people globally can impact on sentiment. The other scenario is more of a serious stir for Mr Bond. We could enter a mini-bear market in bonds with 10-year yields heading back to their pre-crisis levels of close to 2%. It could be even worse if markets get any whiff that central banks want to slowdown balance sheet expansion or if there are any concerns about huge government borrowing needs. I think that is too dramatic, but a material increase in yields would change the outlook for returns across all markets even with a strong economic situation developing. Indeed, an economic boom might not mean a boom in financial market returns coming after such a surprisingly good 2020.