Invesco Perpetual’s Henley Fixed Interest team, Paul Read, Mike Matthews, Stuart Edwards and Julien Eberhardt, review bond markets through 2015 and the prospects for 2016.
What can we expect from fixed interest markets in 2016?
Paul Read: My expectations for bond market returns through 2016 continue to be modest and investors need to manage their expectations. In 2015 we saw some volatility, particularly within credit markets, and yields and spreads are both higher than at the start of 2015. One needs to be careful though, whilst the credit market as a whole is less expensive, bond yields are still very low (see Figure 1) and in many cases the yield increase of bonds we would want to buy has been modest. So whilst arguably we are beginning 2016 in a slightly stronger position than 2015 we remain cautious.
Figure 1: Bond yields are still very low
Source: BofA Merrill Lynch data to 31 December 2015
What’s your view on the current macro-economic environment?
Stuart Edwards: I think we are at an inflection point where we are moving from a market dominated by the echoes of the Global Financial Crisis in 2008 to one that is approaching normality. Since 2008 the focus has been on capturing distressed opportunities within bonds that trade with a yield spread over core government bonds, in other words credit risk or the risk of default. As the market has ebbed and flowed between periods of “risk on” and “risk off” the best opportunities to exploit credit risk have been within financial credit and peripheral European sovereign bonds and this is where we have held some of our larger positions. As the market normalises we would expect to see an increasing focus on the macro-economic cycle and the opportunities that this presents. This should bring to the fore opportunities for duration positioning; yield curve trades, relative value trades and foreign exchange opportunities.
What do you think will be the impact of higher US interest rates on bond markets?
Paul Read: I think that’s an interesting question, which doesn’t have a simple answer. On the one hand, the fact that the US Federal Reserve feels confident enough in the US economy to finally begin hiking interest rates is a good thing. It’s a sign that the US economy and the monetary policy cycle are both returning to normal and all else being equal that should in my view be good for both credit and equity markets. What is more challenging is that this is the start of the first hiking cycle for US interest rates for nine years. That’s a very long time. A lot of people in the market now have never had the experience of trading through a rate tightening cycle. I think this means there is a real risk that now the tightening cycle has begun the market could start to price in more hikes. This could in turn lead to greater volatility, particularly within the government bond market. Indeed, if economic data or inflation is stronger than expected it could become quite challenging for some parts of the bond market.
What about the US dollar?
Stuart Edwards: From a multi-year viewpoint I think that the strength of the US economy and the US Federal Reserve’s tightening of monetary policy should be supportive of the US dollar, but in the short term there will continue to be opportunities to oppose this view. An obvious example is the level of the dollar versus the euro. Ultimately there is no reason why one euro should not be worth one dollar, or indeed why it should not be worth less, but we are likely to see further technical resistance as these levels get tested before the dollar can strengthen further. This could present tactical opportunities.
Figure 2. Trade weighted US dollar index
Source: Bloomberg as at 31 December 2015
Is the pickup in high-yield yields and spreads a cause for concern, or has it created opportunities?
Paul Read: I think it’s a bit of both. I think you need to be very careful about looking at generic spread widening and deciding that a market is cheap, because there’s a lot of sector- and stock-specific influence over where the index is. And actually, as an investor, when you look at what you want to buy, often it’s not that cheap. Having said that, what’s happened in 2015, I think, has led to a slightly more rational high-yield market. I think that primary-market pricing is improving, and I do think there are some secondary-market opportunities and some stock-picking opportunities in fixed income. So, overall I think the high yield market has improved through 2015 but investors should still manage expectations about the capital upside and think of this as an asset class that has the potential to provide reasonable levels of income.
Figure 3. European currency high yield bond spreads
Source: BofA Merrill Lynch European Currency High Yield Bond Index. Data to 31 December 2015
What’s your view on investment grade corporate bond markets?
Mike Matthews: Investment grade corporate bond markets are still challenging. Credit spreads have widened and yields are off their lowest levels. However, in most cases yields are still low and leave only limited potential for further capital appreciation. As we begin 2016 the market could face headwinds from higher government bond yields, rising default rates in the US and potentially issues surrounding liquidity. I think this means it is still prudent that we remain relatively defensively positioned and hold relatively high levels of liquidity. In terms of opportunities – the one sector that we are still focused on is financials given they continue to improve their balance sheets and are still under the regulatory spotlight. I think it is increasingly important to focus on individual bonds rather sector selection because spread widening can be significant for issuers that have problems or are involved in mergers and acquisitions. Overall, while we are still able to find opportunities they are reasonably limited. That said investment grade corporate bond markets can deliver much needed income and generally I prefer them over the alternatives of cash, government bonds or high yield.
Figure 4. Sterling investment grade bond market spreads
Figure 5. Sterling investment grade corporate bond yields
Source: BofA Merrill Lynch Sterling Corporate Bond index. Data to 31 December 2015
Liquidity continues to dominate headlines, what’s your view?
Mike Matthews: I think investors need to be aware of the issues and as always make sure they are being paid for the risks. I believe there is a high probability that liquidity never becomes a significant issue given that it is so well known and investors are managing their own liquidity more. However, personally I expect illiquid markets will create some opportunities and I think it is something we have to consider when managing our portfolios. What I mean by that is investors with cash at a time when others are being forced to sell bonds may be able to drive attractive bargains. This is why across our funds we have for quite some time maintained high levels of liquidity by holding increased levels of cash, government bonds and bonds close to maturity.
Financials are still a big focus for the team, is there still value there?
Julien Eberhardt Financials are still relatively attractive in the team’s view offering a reasonable balance of risk and reward. In our opinion the strengthening of banks’ balance sheets and reduction in the amount of risk weighted assets held has improved creditworthiness. On the other hand, we have seen bank revenues coming under pressure and company specific issues have been a feature of 2015. Overall though, through 2015 subordinated debt has performed well and I am positive on the sector. Looking ahead, I think it will remain important to be selective, with in-depth credit analysis crucial. In addition to being cognisant of company specific risks there are three other factors I am focusing on that I believe could impact the sector; the tightening of US monetary policy, the increase of political risk as a result of the rise of anti-austerity political parties and finally geopolitical concerns.
What does this all mean for positioning in the funds the team manage?
Paul Read: For our mixed asset funds we currently like equity as a source of income – the very low level of bond yields presents a very low hurdle rate for equities to outperform and over the medium term we believe there are all sorts of tailwinds supportive of the asset class. Given the potential headwinds facing bond markets and with government bond yields low and credit spreads less than compelling we are defensive across all the funds. We are maintaining a low duration position, preferring to take credit rather than interest rate risk. That being said I also think it is important for us to not stretch for yield because the market is simply not compensating us for doing so. In terms of positioning this means we are focused on the better quality end of high yield bond market, some investment grade corporate bonds and the financial sector. Against this we have a lot of liquidity across the board. This gives us a lot of flexibility so if volatility picks up, we are well positioned to take advantage of it.