Read the popular financial press and you might come away thinking fixed income is generally a terrible investment at the moment. In recent weeks we have been told Warren Buffett thinks “fixed income investors worldwide…face a bleak future”, while Ray Dalio has declared the economics of investing in bonds has become “stupid” and shorting them is “a relatively low-risk bet”.
In my view, those with the kind of profile enjoyed by Buffett and Dalio – especially among retail investors – should be more accurate with their words. Saying “bonds” are a bad investment is a little like saying it’s going to rain tomorrow, without divulging when or where.
What I think they are specifically referring to here is lower yielding, higher rated bond markets such as US Treasuries, and in fairness to them they might have a point. 10-year UST yields may have climbed some 78bp year-to-date to around 1.7%, but even at this level I think they offer little in the way of income and holders remain exposed to capital losses from a likely further upward shift in yields. While I see less upward pressure on European sovereign yields, the argument for other major ‘risk-free’ rates assets such as UK Gilts and German Bunds is hardly any stronger in my view.
What Buffett and Dalio fail to mention is that with a global view and a multi-sector approach, it is possible to build a bond portfolio with moderate duration of 3-4 years targeting yields of around 4%, which in my view would be a reasonable return in the current climate.
Active managers normally look to constantly recalibrate rates risk and credit risk in their portfolios as conditions change.
With rates risk looking poorly rewarded currently, we would expect them to look to embrace credit risk instead. In the spring of 2020 ratings agencies were forecasting some truly alarming default rates, but fast forward 12 months and we are already seeing more upgrades than downgrades across both US IG and high yield, and according to those same ratings agencies we may be heading for sub-5% HY defaults in the US and sub-3% in Europe by the end of 2021.
With this in mind we anticipate managers wanting to move down the credit spectrum and add pro-cyclical risk, both to try to benefit from the anticipated contracting spreads driven by the economic recovery, and to gain some protection against rates weakness that higher yield bonds usually provide. Where for much of 2020 in our opinion we saw the best value credit risk in bonds around the BBB rating level, we now see an increasing number of opportunities for good bottom-up investments in the BB and B brackets, and potentially lower.
A sharp economic recovery should of course be broadly positive for credit, but this doesn’t mean we can just buy anything; in our view you need to target the parts of the market where you think credit risk is most likely to trump rates risk. Let’s say an investor buys an investment grade corporate bond today at a spread of 30bp over Treasuries. Most of the risk in that position comes from Treasuries, since if the UST yield was to rise by 30bp to 2%, then even if the company performs very well its spread is unlikely to contract by 30bp to offset the Treasury move. With a high yield bond at a spread of say 300bp, meanwhile, there is much greater scope for the credit risk to overwhelm the rates risk.
Global bond investors must also judge where rates weakness might have the most detrimental impact if sovereign yields continue to drift higher, which means picking the right yield curve to ‘hang’ your credit risk off.
As of April 7 the euro high yield index had returned 1.85% year-to-date, versus 1.46% for US high yield. Given the growth momentum of the US economy that might seem puzzling, but much of the discrepancy can be explained by US HY being priced off the US yield curve, and thus hit harder by the particular weakness in Treasuries (plus the US index has slightly higher duration).
At the moment we would generally prefer to have our credit risk priced off the European yield curve, which we see as more stable than its US cousin in the medium term as a result of the European Central Bank’s hefty asset purchase programme and our much more serene outlook for economic growth and inflation in the Eurozone. However, that doesn’t mean we think you want to avoid US credit completely. Given the growth trajectory in the US, we would expect to see some especially positive credit stories in lower rated bonds in the next couple of years, particularly in the three- to five year part of the curve where lower duration should help protect investors from the likely corrosive impact of rising Treasury yields.
Ultimately our outlook for fixed income in 2021 is for credit spread tightening across nearly all geographies and sectors, with credit spread compression between ratings bands.
If 2020 was all about markets rallying ahead of the fundamental recovery – which in part has provoked comments like those we’ve seen from Buffett and Dalio – we think this year will be about economies catching up, fuelled by the huge market drivers of fiscal stimulus and extraordinary monetary policy. While there are certainly risks to this narrative given its reliance on the success of COVID-19 vaccine rollouts, I don’t believe this is the time to play contrarian; markets tend to do well when the direction of travel looks to be clear.
History shows bond investors have done well from embracing pro-cyclicality in trying to pursue returns as the cycle progresses. Some areas where we think managers may look to continue this approach would be by favouring financials, unsecured over secured bonds, corporate hybrids, European CLOs and individual names in hard currency emerging markets.
In particular, financials have had a particularly strong 12 months and have emerged from this challenging period with more capital than when they started; they would be at the top of my credit shopping list right now. We expect subordinated bonds to bounce back quicker than seniors through the recovery, which makes Additional Tier 1 (AT1) bonds look especially attractive in our view. At the index level, in US dollars, AT1s currently yield around 4% for an average maturity of 3.5 years, with a spread over Treasuries of 370bp – there looks to be plenty of spread here to help defend against further rates weakness.
What we expect managers will definitely want to avoid is lower spread and longer dated products, particularly those tied to the US yield curve. In credit, we believe investors should be very wary of sectors ordinarily considered pro-cyclical which are under real structural pressures, such as automotive, travel, retail and commercial property.
Buffett and Dalio see fixed income investors being caught uncomfortably between inflation induced capital losses and unattractively low levels of income. But viewing current fixed income markets through a multi-sector lens provides a more nuanced picture. Treating benchmark sovereign yields as wholly representative of fixed income markets in our view ignores compelling opportunities.
While finding income in the bond markets of 2021 is undoubtedly challenging, we think a portfolio that is able to run relatively low duration with a yield of around 4% remains achievable and would be attractive to investors.
