Doesn't feel good
August 15, 2019

View from the Bond Market, by Chris Iggo, CIO Fixed Income, AXA Investment Managers

Bond yields only go lower

Dragging below 0 percent

Long-end action

Never mind rates, what about credit?

Higher yield means more credit risk

Unknown unknowns

Boost demand

Winning with kids

Summary – Bond yields have plunged this summer. The cyclical slowdown and a wall of political worries has created a surge in demand for safe assets. Investors are trying to figure out what it all means. Will there be a US recession? Will there be a risk asset bear market? Will there be a financial accident somewhere? It's hard to find answers and difficult to see any policy guidance. There is nothing to stop yields falling further but if they do the risk is that credit spreads go wider. It's one thing lending to a government for a negative return, it's entirely another thing lending to a company. And for bond investors it is becoming harder to mitigate against the impact of lower yields on portfolio decisions. It might not be the time to take more credit risk yet there is incrementally less reward for extending out along the yield curve. This year's returns to bond portfolios are very strong. We need to be mindful of the risk that it will be much harder to sustain those kinds of returns going forward.

Bond yields only go lower – When I left the office for my summer holiday in Mallorca last month (and yes, I had a great time thanks) the yield on the US treasury ten-year benchmark bond was 2.05 percent. Today it is 1.58 percent. That has been quite a move. The US Federal Reserve (Fed) cut rates on July 31 by 25 basis points (bps) but this had been well anticipated at the time and the sharp decline in government bond yields over the first half of the summer has not been just a US phenomenon. German bund yields have dropped by more than 30 bps over the same period and now trade with a negative 0.65 percent yield. The entire German government bond market is now trading with negative yields. Japanese yields are down a further ten bps, French yields are down over 35 bps and the UK gilt yield is trading at 0.45 percent compared to 0.75 percent when I left the office. These are massive moves, driven by fears over the economic outlook and policy and political uncertainty. Investors need safe assets and have woken up to the value of long-dated bonds in terms of protecting capital and delivering positive returns when equities are under pressure. Global economic data continues to weaken and this week alone we have seen negative quarterly gross domestic product (GDP) prints in the UK and Germany, not to mention renewed weakness in Chinese data. Investment strategies based on the expectation of strong and stable economic growth are just not rewarding at this time. Bonds could continue to perform as a result, even with, in some cases, historically low yields.

Dragging below 0 percent – However, we face unprecedented conditions in the bond market. In the European investment grade corporate bond market, more than 40 percent of all issues are trading with a negative yield to worst. In the European government bond market the percentage is 60 percent. From ten-years out the entire German sovereign curve is some 40 bps lower than the equivalent Japanese yield curve, which says something awful about the longer-term economic outlook for Europe given Japan's already long history of deflation and weakening demographics (not to mention sky-high debt pile). Yields on UK government debt remain positive at around 1 percent in the long-end, largely because the Bank of England has resisted cutting interest rates for fears of provoking a further rout in sterling given the increased probability of a "no-deal" Brexit. However, the UK yield curve is now negative between two-year and ten-year gilts, a sign that the market believes strongly that the Bank of England should be cutting interest rates.

Long-end action – So despite very strong returns in bond markets this year, the level of yields now gives me cause to doubt that this year's level of investment returns can be sustained. The dynamic in most government bond markets has been for yield curves to flatten and longer-dated yields to fall more than short rates. This has created a differential return profile between short and long maturity sectors in the bond market. For example, in the German government bond market the one- to three-year sector has a total return of -0.08 percent year-to-date while the ten-15 year sector is up 7.1 percent. In the US the equivalent returns have been 2.3 percent and 7.7 percent and in the UK the numbers are 1.0 percent and 7.5 percent. Shorter maturities in government bonds might get some boost from further central bank easing. The Fed is likely to ease again before year-end, the Bank of England could do so if Brexit creates market volatility and the European Central Bank (ECB) might even reduce the deposit rate further as part of a new round of easing measures once Mme Lagarde is in place. Yield curves could also continue to flatten, driven by investor demand for duration and higher yielding assets. We do not know the limit to how far this can continue but the incremental yield for taking higher duration risk is getting less and less. Still, as I have said many times, yield is not always equated to return, and you get more return for a 1 bp move in a 30-year bond than in a five-year bond. Thus, long rates might keep getting lower and lower.

Never mind rates, what about credit? – The flatter curves go the more we are likely to have to start being concerned about recession and the performance of riskier asset classes. The economic signal from ongoing flattening of government curves is a negative one given the limited ability for central banks to reduce interest rates significantly outside of the US, While equity valuation could be superficially supported by lower and lower long-term risk-free rates, the economic implications of zero nominal GDP growth must ultimately cause sharp downward revisions to earnings growth estimates and impact on the confidence of investors to take equity risk. This could all be compounded by the wall of worry around policy and politics. Political issues such as Brexit, the belligerence of US foreign policy, the Hong Kong protests, the uncertainty in Argentina and Italy all clearly have a local genesis but are tied together by a shift in the global political hegemony that has its roots in popular discontent at the failure to deal with the issues unleashed by the financial crisis a decade ago. We have already seen how this populism can impact on economic policy and, by extension, volatility in asset markets. The US-China trade war has hit global manufacturing, an early Italian election could again challenge the notion of Italian compliance with EU fiscal stability rules, and Brexit could unleash a wave of populist spending in the UK. All of this seems a long way from expectations of long-term stable growth based on a stable inflationary targeting monetary regime, prudent fiscal rules, technological change and globalisation (the basis for optimism over the last twenty years).

Higher yield means more credit risk – In both the government and corporate bond markets the only way to really add yield at the moment is to go down the credit curve. Adding duration does not do much given how flat curves have become. Eliminating all negative yielding bonds from the European credit market would raise the yield from 0.3 percent to 0.64 percent with a slight deterioration in the average rating. Yet the higher yielding bonds are likely to be the ones most at risk from a continuation of current trends – negative yields impacting on weak banks, corporates at risk from further cyclical weakness and so on. If you want yields above 1 percent then there is only the BBB rated buckets. In terms of portfolio strategy this means a more total return rather than a benchmark tracking approach with probably some credit hedges in place to limit overall volatility. Interestingly, credit markets have generally provided positive excess return relative to government bonds this year. However, spreads have started to wide. Credit default swap indices have moved wider this month so far and spreads on cash bonds are 20-50 bps wider depending on the sector. While bond yields are lower, credit spreads remain well below the highs they reached last December. This is also true of equity markets which, despite recent volatility, are still above last December's levels. Does this matter? Does it mean risk assets have got further to fall? The big difference between now and the end of last year is that the Fed has cut rates and globally monetary policy is firmly in easing mode. Still, there must be a danger of further risk market underperformance.

Unknown unknowns – In 2008, most people in the markets had no idea about the leveraged web of instruments that were ultimately linked to the housing market in the US. Today we can only guess what the potential implications of a prolonged period of negative bond yields will have on the financial sector and the economy. There could be an impact on pension fund valuations, on insurance company solvency and on bank profitability. In the Euro corporate market, banks have underperformed the credit index by over 1 percent since the end of Q1. So far insurance companies have performed well from a credit point of view given their ability to be more flexible on the balance sheet – adding alternatives and higher yielding assets and reducing exposure to just government bonds. I note a piece from one of the investment banks this week that argues that Dutch pension funds might have to start reducing pension benefits because of the deterioration in solvency ratios caused by the decline in bond yields. We should be worried about lower and lower bond yields because they are sending very negative signals about the economic outlook, but they may cause some (as yet not fully understood) tensions in the financial system with structural implications.

Boost demand – From a macro point of view it seems that we can't just rely on monetary policy. Fiscal policy must be used as well with governments borrowing money to finance increased deficits that allow tax cuts or spending increases. Yes, this will add to debt but there is clearly plenty of global savings to absorb the debt. If we did see such a policy response, then I would certainly shift my focus in the bond market forwards. Yield curves might steepen again. Inflation risk premiums could possibly increase. Both the US and UK consumer price data surprised to the upside in July with core US inflation now up to 2.2 percent and the UK equivalent at 1.9 percent. Aggregate demand needs to be stimulated and the most effective way to do this would be through government borrowing and taking advantage of borrowing costs that will, ultimately, turn out to be negative in real terms. That additional aggregate demand should stimulate inflation, especially if done across developed countries. I doubt holding one's breadth for such an outcome is a wise strategy, but at this stage I can't see much upside unless we do get either a resolution to all aspects of the wall of worry or a co-ordinated and radical set of policy decisions.

Winning with kids – Coming back from holiday to the start of the football season always provides some excitement. Imagine my joy when I switched my phone from "Airplane Mode" on Sunday afternoon to see that (Manchester) United had banged four in against Chelsea. After six years of frustration I know better than to get too excited after just one Premier League game, a handful of (successful) pre-season matches and a limited transfer window. Having said that, the squad does look fresher. Ole seems to be getting his way in terms of playing style, there is a youthfulness about the team and expectations are that United will struggle to finish in the top four again. The hurdle to it being a good season is quite low then. Next up is an away game to Wolves – a bit of a bogey team last year. A result there would demonstrate real progress. After one game, United are above Liverpool and no one expects that to be sustained through the season (it's their turn – again). Let's see. Oh, and by the way, my other team, Sheffield Wednesday, are top of the Championship. I like this.

Have a great weekend,

Chris





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View from the Bond Market, by Chris Iggo, CIO Fixed Income, AXA Investment Managers

Bond yields only go lower

Dragging below 0 percent

Long-end action

Never mind rates, what about credit?

Higher yield means more credit risk

Unknown unknowns

Boost demand

Winning with kids

Summary – Bond yields have plunged this summer. The cyclical slowdown and a wall of political worries has created a surge in demand for safe assets. Investors are trying to figure out what it all means. Will there be a US recession? Will there be a risk asset bear market? Will there be a financial accident somewhere? It's hard to find answers and difficult to see any policy guidance. There is nothing to stop yields falling further but if they do the risk is that credit spreads go wider. It's one thing lending to a government for a negative return, it's entirely another thing lending to a company. And for bond investors it is becoming harder to mitigate against the impact of lower yields on portfolio decisions. It might not be the time to take more credit risk yet there is incrementally less reward for extending out along the yield curve. This year's returns to bond portfolios are very strong. We need to be mindful of the risk that it will be much harder to sustain those kinds of returns going forward.

Bond yields only go lower – When I left the office for my summer holiday in Mallorca last month (and yes, I had a great time thanks) the yield on the US treasury ten-year benchmark bond was 2.05 percent. Today it is 1.58 percent. That has been quite a move. The US Federal Reserve (Fed) cut rates on July 31 by 25 basis points (bps) but this had been well anticipated at the time and the sharp decline in government bond yields over the first half of the summer has not been just a US phenomenon. German bund yields have dropped by more than 30 bps over the same period and now trade with a negative 0.65 percent yield. The entire German government bond market is now trading with negative yields. Japanese yields are down a further ten bps, French yields are down over 35 bps and the UK gilt yield is trading at 0.45 percent compared to 0.75 percent when I left the office. These are massive moves, driven by fears over the economic outlook and policy and political uncertainty. Investors need safe assets and have woken up to the value of long-dated bonds in terms of protecting capital and delivering positive returns when equities are under pressure. Global economic data continues to weaken and this week alone we have seen negative quarterly gross domestic product (GDP) prints in the UK and Germany, not to mention renewed weakness in Chinese data. Investment strategies based on the expectation of strong and stable economic growth are just not rewarding at this time. Bonds could continue to perform as a result, even with, in some cases, historically low yields.

Dragging below 0 percent – However, we face unprecedented conditions in the bond market. In the European investment grade corporate bond market, more than 40 percent of all issues are trading with a negative yield to worst. In the European government bond market the percentage is 60 percent. From ten-years out the entire German sovereign curve is some 40 bps lower than the equivalent Japanese yield curve, which says something awful about the longer-term economic outlook for Europe given Japan's already long history of deflation and weakening demographics (not to mention sky-high debt pile). Yields on UK government debt remain positive at around 1 percent in the long-end, largely because the Bank of England has resisted cutting interest rates for fears of provoking a further rout in sterling given the increased probability of a "no-deal" Brexit. However, the UK yield curve is now negative between two-year and ten-year gilts, a sign that the market believes strongly that the Bank of England should be cutting interest rates.

Long-end action – So despite very strong returns in bond markets this year, the level of yields now gives me cause to doubt that this year's level of investment returns can be sustained. The dynamic in most government bond markets has been for yield curves to flatten and longer-dated yields to fall more than short rates. This has created a differential return profile between short and long maturity sectors in the bond market. For example, in the German government bond market the one- to three-year sector has a total return of -0.08 percent year-to-date while the ten-15 year sector is up 7.1 percent. In the US the equivalent returns have been 2.3 percent and 7.7 percent and in the UK the numbers are 1.0 percent and 7.5 percent. Shorter maturities in government bonds might get some boost from further central bank easing. The Fed is likely to ease again before year-end, the Bank of England could do so if Brexit creates market volatility and the European Central Bank (ECB) might even reduce the deposit rate further as part of a new round of easing measures once Mme Lagarde is in place. Yield curves could also continue to flatten, driven by investor demand for duration and higher yielding assets. We do not know the limit to how far this can continue but the incremental yield for taking higher duration risk is getting less and less. Still, as I have said many times, yield is not always equated to return, and you get more return for a 1 bp move in a 30-year bond than in a five-year bond. Thus, long rates might keep getting lower and lower.

Never mind rates, what about credit? – The flatter curves go the more we are likely to have to start being concerned about recession and the performance of riskier asset classes. The economic signal from ongoing flattening of government curves is a negative one given the limited ability for central banks to reduce interest rates significantly outside of the US, While equity valuation could be superficially supported by lower and lower long-term risk-free rates, the economic implications of zero nominal GDP growth must ultimately cause sharp downward revisions to earnings growth estimates and impact on the confidence of investors to take equity risk. This could all be compounded by the wall of worry around policy and politics. Political issues such as Brexit, the belligerence of US foreign policy, the Hong Kong protests, the uncertainty in Argentina and Italy all clearly have a local genesis but are tied together by a shift in the global political hegemony that has its roots in popular discontent at the failure to deal with the issues unleashed by the financial crisis a decade ago. We have already seen how this populism can impact on economic policy and, by extension, volatility in asset markets. The US-China trade war has hit global manufacturing, an early Italian election could again challenge the notion of Italian compliance with EU fiscal stability rules, and Brexit could unleash a wave of populist spending in the UK. All of this seems a long way from expectations of long-term stable growth based on a stable inflationary targeting monetary regime, prudent fiscal rules, technological change and globalisation (the basis for optimism over the last twenty years).

Higher yield means more credit risk – In both the government and corporate bond markets the only way to really add yield at the moment is to go down the credit curve. Adding duration does not do much given how flat curves have become. Eliminating all negative yielding bonds from the European credit market would raise the yield from 0.3 percent to 0.64 percent with a slight deterioration in the average rating. Yet the higher yielding bonds are likely to be the ones most at risk from a continuation of current trends – negative yields impacting on weak banks, corporates at risk from further cyclical weakness and so on. If you want yields above 1 percent then there is only the BBB rated buckets. In terms of portfolio strategy this means a more total return rather than a benchmark tracking approach with probably some credit hedges in place to limit overall volatility. Interestingly, credit markets have generally provided positive excess return relative to government bonds this year. However, spreads have started to wide. Credit default swap indices have moved wider this month so far and spreads on cash bonds are 20-50 bps wider depending on the sector. While bond yields are lower, credit spreads remain well below the highs they reached last December. This is also true of equity markets which, despite recent volatility, are still above last December's levels. Does this matter? Does it mean risk assets have got further to fall? The big difference between now and the end of last year is that the Fed has cut rates and globally monetary policy is firmly in easing mode. Still, there must be a danger of further risk market underperformance.

Unknown unknowns – In 2008, most people in the markets had no idea about the leveraged web of instruments that were ultimately linked to the housing market in the US. Today we can only guess what the potential implications of a prolonged period of negative bond yields will have on the financial sector and the economy. There could be an impact on pension fund valuations, on insurance company solvency and on bank profitability. In the Euro corporate market, banks have underperformed the credit index by over 1 percent since the end of Q1. So far insurance companies have performed well from a credit point of view given their ability to be more flexible on the balance sheet – adding alternatives and higher yielding assets and reducing exposure to just government bonds. I note a piece from one of the investment banks this week that argues that Dutch pension funds might have to start reducing pension benefits because of the deterioration in solvency ratios caused by the decline in bond yields. We should be worried about lower and lower bond yields because they are sending very negative signals about the economic outlook, but they may cause some (as yet not fully understood) tensions in the financial system with structural implications.

Boost demand – From a macro point of view it seems that we can't just rely on monetary policy. Fiscal policy must be used as well with governments borrowing money to finance increased deficits that allow tax cuts or spending increases. Yes, this will add to debt but there is clearly plenty of global savings to absorb the debt. If we did see such a policy response, then I would certainly shift my focus in the bond market forwards. Yield curves might steepen again. Inflation risk premiums could possibly increase. Both the US and UK consumer price data surprised to the upside in July with core US inflation now up to 2.2 percent and the UK equivalent at 1.9 percent. Aggregate demand needs to be stimulated and the most effective way to do this would be through government borrowing and taking advantage of borrowing costs that will, ultimately, turn out to be negative in real terms. That additional aggregate demand should stimulate inflation, especially if done across developed countries. I doubt holding one's breadth for such an outcome is a wise strategy, but at this stage I can't see much upside unless we do get either a resolution to all aspects of the wall of worry or a co-ordinated and radical set of policy decisions.

Winning with kids – Coming back from holiday to the start of the football season always provides some excitement. Imagine my joy when I switched my phone from "Airplane Mode" on Sunday afternoon to see that (Manchester) United had banged four in against Chelsea. After six years of frustration I know better than to get too excited after just one Premier League game, a handful of (successful) pre-season matches and a limited transfer window. Having said that, the squad does look fresher. Ole seems to be getting his way in terms of playing style, there is a youthfulness about the team and expectations are that United will struggle to finish in the top four again. The hurdle to it being a good season is quite low then. Next up is an away game to Wolves – a bit of a bogey team last year. A result there would demonstrate real progress. After one game, United are above Liverpool and no one expects that to be sustained through the season (it's their turn – again). Let's see. Oh, and by the way, my other team, Sheffield Wednesday, are top of the Championship. I like this.

Have a great weekend,

Chris



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