Threadneedle’s Cielinski discusses how to navigate bonds in a slow-growth world
Jim Cielinski, head of Fixed Income at Threadneedle Investments, outlines what to expect from bond markets at a time of slow global growth.
Q: Core government bond yields are at historic lows. What does this tell us?
It tells us a couple of things. Firstly, that there is a lot of uncertainty out there, and that the valuation differential between what the market views as safe and what it regards as risky has widened to extreme levels. You just have to compare US, UK or German government bond yields with those of Greece or Spain to see the difference. And secondly, it tells us that the core markets are being rigged by the authorities, with central banks anchoring policy rates at extremely low levels and buying much of the new long-term issuance. This disconnect is deliberately engineered to keep yields artificially low and can persist for some time. It is a stealth tax on savers.
Q: Why are core bond yields being kept so low?
It is a policy designed to encourage assets to flow out of lower risk investments and into the real economy. Core government bonds have traditionally been seen as offering a risk-free return but, with base rates and government yields below the rate of inflation, they are actually offering a return-free risk. Moreover, we should not underestimate that economic risks are high, inflationary pressures are peaking and there is a genuine dearth of ultra-high quality assets. An overvalued bond market is perhaps not overly surprising.
Q: So do you see any value in core markets at these levels?
For the first time in my career, I am finding it hard to come up with compelling reasons to own core government bonds. If you invest at these levels you are locking in a negative real return. Aggressive policy will keep yields from rising sharply but, by the same token, the scope for yields to fall further is very limited. There is a limit on the positive returns that the market can offer, which also undermines the rationale to use government bonds as a hedge versus other asset classes such as equities.
Q: What about peripheral European markets? The yields available in these markets are much higher.
They are much higher, but are they more attractive? I don’t think so. This is the great conundrum facing bond investors: yields on “safe” markets are so low as to make negative real returns likely, but if you go looking for higher yields, they often come accompanied by unacceptably high default risk. Furthermore, in many cases the risks are not analysable from a bond investor’s perspective: in the case of the eurozone, for example, many of the risks are based on political decisions, which are hard to assess. There is a high level of policy risk and a wide range of potential outcomes and, as a result, peripheral European bonds are no longer performing as you would expect government bonds to perform. It is hard to justify investing, even at the high yields that we’re seeing, until a credible eurozone resolution is likely
Q: Are there any areas where the risk/reward looks more appealing?
Yes, there are. I think in this environment of great uncertainty, you have to look for issuers whose destiny is in their own hands, and we see a couple of examples. One is emerging market bonds. In general, emerging market credit fundamentals are far superior to those in the developed world. These countries have well-financed and fully functional banking systems, better economic growth and healthy foreign exchange reserves, which means that they have the policy tools to navigate any further turbulence. And yet they still offer a yield premium over US treasuries, so we find that interesting. The second area is corporate credit, and in particular high yield bonds. The excess yield that you can earn by owning these bonds is higher than we think is justified by the risk of default. In other words, there is a larger than normal liquidity premium built into these bonds. With a starting yield of around 8%, this asset class should generate a positive total return in most environments. There will be volatility, as you would expect from any risk asset, but there is a good chance of decent returns across a range of scenarios.
Q: What are the main scenarios that you have modelled?
We’ve looked at three main scenarios: severe recession, slow growth and recovery. Using current valuation levels and the likely moves in yields and spreads in each of these cases, we have arrived at expected returns from various bond classes. Recession is the only scenario in which government bonds produce the highest returns – in fact it is the only one where gilts produce positive returns. Corporate and emerging market bonds do much better in the slow growth and recovery cases. Don’t forget that these classes do not require robust growth in order to do well – the issuer just needs to be able to pay coupons and return the principal investment at maturity. We don’t know with certainty which scenario will unfold but the distribution of possible returns over the medium term is certainly more attractive in credit and emerging markets than it is for core government markets.
Q: Are we nearing the end of the deleveraging phase?
No, the deleveraging phase has a good deal further to run and it will continue to be a key investment theme across all asset classes for several years. Governments and consumers still have a long way to go before debt levels return to historic norms and growth will remain constrained until the situation is normalised. In the corporate sector, many companies deleveraged early and are now in good shape, which is another reason why we prefer corporate bonds to governments. One exception is the banking sector: a number of European banks in particular still need to reduce leverage and raise capital. There are some interesting valuation opportunities in the banking sector and, if you choose carefully, there are potentially good returns to be made. However, you have to be very careful in stock selection terms, because there are lots of banks that will not be around five years from now.
Q: Do you expect further liquidity injections from central banks?
Yes, I think it is highly likely that further liquidity will be injected to offset the deflationary effects of deleveraging. Liquidity is one of the last tools at the central banks’ disposal and we have seen before that, when markets encounter extreme stress, liquidity is the tool of choice. We are in the middle of an epic battle between low growth and liquidity and history tells us that liquidity normally prevails. It may take time, but eventually the threat of deep recession and deflation should be averted by prolonged excess liquidity. This means that further quantitative easing, in all of its guises, is highly likely.
Q: What will be the main beneficiaries of this excess liquidity?
The authorities would like it to end up in the real economy, via increases in corporate capital expenditure and private consumption, but I think we are some way off those two outcomes happening. More likely is that the liquidity will find its way into financial assets. This is what we have seen in the waves of quantitative easing to date – the cheapest financial assets rally, and the authorities will accept this as an outcome because there is a chance that some of the profits from this rally will ultimately end up in the real economy.
Q: Wrapping up, what would you say are the main themes in fixed income?
The biggest theme is that the way we think about risk and return has changed forever. There has been a blurring of the boundaries between developed and developing markets, and between government and corporate markets. Valuations of relatively safe assets are very expensive, and it is hard to find attractive returns without taking big risks. But there are areas that can provide decent returns without unacceptable risk.
In addition, deleveraging still has a long way to go and this will mean low growth, with fears of recession and deflation from time to time. To combat this, interest rates are going to stay low for a long time in the developed world, reinforcing the search for income.
Thirdly, we can expect further liquidity injections if things get worse in Europe and this liquidity is likely to boost attractively valued risk assets within fixed income and beyond. And finally, we need to accept that volatility is going to remain a feature of all markets. This means that we need to look beyond the short-term news flow, return to fundamentals and take advantage of changes in prices to invest in those assets that we think have the best long-term return potential.