Bonds: Always stay “in” or you may become a loser
Investors experienced six months not short of challenges at all and the following semester could even surpass the first one.
Looking back, 2016 kicked off with the worst start in a decade. The first trading week displayed losses for the majority of asset classes we haven’t witnessed since 1999. Fears related to the impact of the Chinese economic slowdown intensified strongly in January. On the back of this, the oil price retraced to a new multi-year low below USD 30 per barrel. Subsequent months put those concerns into perspectives.
Now, seven months later, oil trades around USD 40 per barrel but keeps its volatility: it reached USD 50 only a month ago. Nevertheless, the general macroeconomic picture is still mixed and not short of challenges. Global economic growth expectations remain weak and uneven across economies, with risks still shifted towards Emerging Markets, despite the recovery in commodity prices.
Speaking about challenges, we also have to focus on the UK as well as on Italy. The outcome of the EU-referendum in the United Kingdom puts not only further pressure on economic growth in the UK, but also across other European economies. Growth prospects for the UK and other developed countries have been reduced by various institutions and will definitely weigh on consumers’ sentiment. Moreover, they will have a negative impact on corporate profits.
Closely after the Brexit, the Italian banking system demonstrates once again its vulnerability as it is trapped in a challenging situation. In general, the main structural problems are related to a substantial amount of non-performing loans, ultra-low rates and a highly fragmented banking market. Politicians have tried to solve the problems through several measures, but none of them has materially changed the situation so far. The latest measure, the privately funded Atlante, has already used the majority of its EUR 4.25 billion firepower as it had to buy nearly all of the shares in the IPOs of Banca Populare di Vicenza and Veneto Banca.
On the positive side, and currently outweighing, we have to recognize the ECB effect with its CSPP-program. Once again, the ECB delivered a first aid kit extending its monetary policy measures and thereby influencing the markets substantially. This time, having more than fulfilled the expectations, the ECB programme pushed credit spreads already in its first weeks significantly tighter. This trend continues and at the moment there are no signs that the ECB will reduce the purchasing volume near-term.
We thus deem the demand for investment-grade rated corporate bonds to remain strong. Especially assets which are in scope of the ECB purchase program should generate a stable return albeit at a lower level than seen in the first half of the year.
Prospects for bonds issued by financial institutions might be less certain as banks are seen as one of the most disadvantaged sectors following Brexit. As the EBA stress test has shown, especially banks in the periphery and/or with a low capital cushion are pressured in an adverse scenario. Nevertheless, this general negative sentiment also creates some attractive investment opportunities, providing a benefit of higher yields of the rock solid banks.
In what concerns the non-investment-grade rated bonds, performance potential is still good, especially considering the quality of companies’ results and their financial profiles. However, we expect the high yield market to remain volatile due to the mentioned uncertainty and a prolonged period of unknown consequences of the UK referendum. Everyone needs to be clear that the current political unrest in Turkey and the coming hot phase of the US electoral campaign will also increase volatility.
It is worth mentioning that, going further, with a number of low-investment-grade rated bonds already delivering negative yields and the primary market being far from saturated, the high yield issuers could witness additional respectively increasing demand. The CSPP purchases could thus indirectly help the high yield market to balance the spikes of volatility while the actual effect and timing will depend on how promptly and at which pace the purchases take place.
Lisa Backes, CIO of YCAP Asset Management.