Investment survival after a rate collapse
The second quarter's collapse in developed market government bond yields seemingly confirmed a trend of mounting economic disappointment where growth and inflation simply remain too low (see the Global Macroeconomics section). As G3 rate markets fell for the third consecutive quarter (see Figure 1) and pointed to the need for more central bank accommodation, the actual tipping points for the institutions varied—the European Central Bank was struck by the market's drop in inflation expectations, while the Federal Reserve and Bank of Japan moved to easing biases as U.S./China trade tensions flared. Although no G3 central bank actually moved, the ECB and the Fed certainly appear poised to act over the balance of the year, if not in Q3.
Figure 1: A Third Consecutive Quarter of Developed Market Rate Declines Left Many Rate Complexes at Multi-year Lows
While U.S./China trade tensions led to a pronounced hiccup in the risk markets in May, they recovered by quarter end, leaving returns for equities and the riskier fixed income sectors in positive territory and even stronger year-to-date thanks to a banner first quarter (see Figure 2). The return bounty certainly belied what many considered to be low levels of yields and spreads at the beginning of the year.
The Course Ahead: Volatile, With Opportunities to Add Value
The bad news first. Lower yields on government debt imply lower expected returns over the long term. Worse yet, thanks to lower rates and longer-dated issuance, the bond market's overall rate sensitivity has increased, boosting the potential for volatility. If rates enter a secular uptrend, it could be a brutal bear market for bonds.
But It May Not Be as Bad as Feared Now, the good news. At least in our view, rates seem more likely to remain rangebound around current, or even lower, levels over the long term. While that idea may seem crazy, the factors covered in our white papers since 2003 that have supported expectations for lower yields—aging demographics, high debt levels, and rising inequality—appear to warrant interest rates at current levels or lower. 1 After all, despite the low level of rates, growth has continued to moderate, and inflation has remained below target, suggesting that, if anything, rates may not yet be low enough to stabilize the economic trajectory.
Bonds May Continue to Outperform Cash, Albeit With Significant Volatility
There's more potential good news. Significant opportunities for adding value in the bond market remain. For one, spreads trade at substantial premiums to underlying yields (see Figures 3 and 4). If and as rates remain low with continuing, slow economic growth, an aggressive search for yield is likely, potentially boosting spread product returns. Furthermore, spreads across various sectors—structured product, emerging market debt, investment grade and high yield corporates, and European peripherals—remain less than perfectly correlated, offering opportunities for sector diversification and rotation.
Figure 3 and 4: If Corporate Credit Risk Remains Contained, the Spread Between European Corporates and 10-year Swaps Looks Quite Different When Compared to an Underlying Market Yield of 5%, 3%, 1%, or just 11 bps—As is Now the Case. In a Slow Moving, Low-Yielding World, It's Not Hard to Imagine the Search for Yield Intensifying.
Bonds Still for Ballast?
The potential portfolio ballast that fixed income provides may be another positive for the bond market. As low as many government yields seem, they could fall even further if their respective economies worsen. Therefore, bonds may dampen portfolio volatility in a recessionary scenario where the riskier assets, such as equities and real estate, could significantly underperform.
Is That a Tax Hike? Shhh—They Think It's Monetary Accommodation!
Among the list of potential positives for the bond market, we'd note the potential for further policy easing by the BoJ or ECB to inadvertently worsen the economic outlook. While QE and lower rates may help an economy that is a net capital user, such as the U.S., it could have the opposite effect in Europe and Japan, which are net saving/capital providing blocs. If the increased focus on "reversal rates" is any indication, the net effect may simply be an income penalty—or a tax considering that the central banks are taking money via negative yields—on investors, savers, and financial institutions.
After all, negative yields generate revenue for the central banks, which accrues to the benefit of the government. Negative yields on bonds issued by the government may also represent a tax windfall as bond holders pay the government to store their money—i.e., the negative yield, either directly or indirectly, benefits government coffers.
Therefore, more aggressive accommodation from the ECB and/or the BoJ could be doubly positive for the bond market. The first order effects of rate cuts and/or additional bond purchases is simply higher bond prices as short-term rates are cut and longer term yields are pushed down through asset purchases and forward guidance. A secondary boost to the bond market could come if economic activity is further dampened as the private sector sees its income cut via lower yields or higher taxes (paying higher negative yields on its cash and bond holdings) and observes asset purchases forcibly increasing the amount of money in the system that is subject to negative yields (see Figure 4).
Figure 4: An Expanding Global Universe of Negative Yielding Fixed Income Assets Recently Hit a High-Water Mark of $12 Trillion
Risks Appear More Prominent with Slim Margin for Error
While our base case argues for staying the course in bonds, albeit with lower return expectations, we have to acknowledge the numerous risks on the horizon. One of the more proximate, if not mundane, risks consists of the seasonal tendency for risk-off moves over the lower-liquidity summer months. These conditions could be exacerbated by the U.S. President's penchant for needling countries on critical economic issues via social media. Additionally, with the economic backdrop downshifting, corporations' second-quarter reports could bring an above-average share of cautious guidance, which could subsequently weigh on risk appetite. Alternatively, signs of faster growth—such as June's stronger-than-expected non-farm payroll report—could scupper the market's current expectations for central bank accommodation and quickly lead to a taper-tantrum like bout of rising rates and widening spreads. Again, not our base case, but always best to be on the lookout for detours.
The Bottom Line: True, it's bad that the Q2 collapse in yields lowered the baseline expectation for bond returns. But to the extent that rates remain low and rangebound—thanks to the general backdrop of moderate growth and inflation—bonds seem likely to continue outperforming cash. Furthermore, spreads remain at attractive levels, and the potential for investor confusion and market volatility remains high. As a result, significant opportunities to add value through sector allocation and relative-value trading remain intact.
Robert Tipp, chief investment strategist and head of global bonds, PGIM Fixed Income
