Bond market sell-off has created opportunities, says Threadneedle’s Cielinski
QE in the US had suppressed bond yields by around 50-75 basis points, according to Jim Cielinski, head of Fixed Income at Threadneedle Investments.
At the start of 2013, we forecast a challenging macro outlook, continued downside risks, and we expected shorter-term interest rates to stay lower for longer. Our fixed income themes for the year were: a search for income; a focus on alpha rather than beta; market volatility; and occasional crises. So far this year, most areas of fixed income have performed poorly as the US Federal Reserve’s ‘tapering’ comments have revealed the overvaluation that existed in many core government bond markets. Some pockets, such as high yield, have fared better. Our main themes for fixed income markets are unchanged.
We believe quantitative easing (QE) in the US had suppressed bond yields by around 50-75 basis points. The recent sell-off removed that premium. However, there is still scope for markets to sell off further – more than £60 billion has already flown out of bond funds since the beginning of June 2013, the worst period on record. Credit spreads, meanwhile, are still at or slightly above their long-term averages. Given robust corporate fundamentals, therefore, we still see attractive opportunities in credit, although investors should not expect a re-run of the stellar returns seen in 2012.
The search for yield continues and will remain a key theme while interest rates are so low.
‘Tapering’ merely involves a shift from hyper-accommodative policy to highly accommodative policy; in other words, interest rates are unlikely to move higher for some time (early 2015 according to current US market pricing). But with yields still low, the focus will be on alpha generation, not just harvesting coupons from bond markets. We will also continue to see more volatility in fixed income in the second half of the year. However, we would view that as an opportunity to create alpha. The recent sell-off in bond markets has removed the liquidity premium that had prevailed, and bond markets are now closer to reflecting fundamentals.
One of the key positives for fixed income is that inflation remains low, especially in developed markets. Therefore, it does not pose the threat to bond markets that it could otherwise do, given that signs of growth are beginning to emerge. Given the low-growth economic environment ahead, we do not believe we are facing an apocalyptic scenario for bond markets, and comparisons with 1994 are wide of the mark in our view.
Within the broad fixed income universe, we see opportunities in emerging markets bonds, especially if global growth continues to pick up. Emerging market (EM) debt was hit hard in the recent sell off. Chinese policy has been less accommodative and has led to a fall in commodity prices, and this has accelerated fears of a slowdown across emerging markets in general. The impact of the rising US dollar on EMs has been magnified by the threat of tapering, and this has also damaged EM currencies.
Unfortunately, the EM policy response has been quite limited. To protect the currency and defend against inflation, EM central banks can intervene in the currency market, or they can raise interest rates, both of which have the effect of tightening monetary policy. We think the sell-off in EM debt has now gone too far. The current situation is a growth issue, unlike previous setbacks in EM debt, which arose from defaults or credit crises. We believe the best way to take advantage of the EM debt opportunity is relative to US treasuries and to capture the yield premium between the two.
Our in-house research also underlines the value in high yield bonds. Credit spreads are still above their long-term averages, despite decent balance sheets, strong cashflow, reasonable growth prospects and low default rate expectations. High yield bonds offer a yield of around 7%, so there is value relative to default rates.
We have run scenarios for total returns from fixed income asset classes in the event of a double-dip recession, slow growth and normal recovery events. If a double-dip recession was to occur, returns from across fixed income assets would be low, even in government bonds, and negative in high yield. In a slow-growth world, emerging market debt and high yield would be expected to strongly outperform, and fare even better in a normal growth environment. Government bonds would be expected to sell off further if normal economic activity re-emerges.
We are still comfortable with the themes we set out at the start of the year. The market movements in May and June are such that we see opportunities in emerging market debt and are positive on high yield bonds. Investment-grade credit is not cheap, but still remains preferable to government bonds. The latter still remain poor value in our opinion, though June’s sell-off means they are now priced for returns in excess of cash.