Fixed Interest

  • Bond funds, both Government and Corporate, produced healthy returns last quarter as yields fell and credit spreads narrowed. The outlook now is for low and stable rates, encouraging investors to take on duration. A more dovish US Federal Reserve Bank is indicating no more interest rate rises this year whilst sharply slowing growth in the Eurozone precludes any tightening from the ECB. Against this backdrop bond yields have fallen, 10 year US Treasuries to around 2.4%, UK 10 year Gilts to 1% and 10 year German Bunds to a yield of -0.07%. The Fed’s dovish stance along with improved US/China trade relations has led to a more ‘risk on’ market stance and along with the rally in equities has led to a narrowing of credit spreads, most notably in the area hardest hit last year, EM Debt and High Yield. Despite this, credit still looks better value than rates with the potential for further narrowing to levels that preceded the big Q4 sell-off last year.
  • The interest rate outlook remains challenging for fixed income investors whose base currency is euros, swissies or yen where domestic yields remain anchored by negative policy rates which aren’t going to change anytime soon (the ECB deposit rate is -0.40%, meaning Banks have to pay the ECB to park money with them!). You have to go beyond 10 years on the German Bund curve to find a positive yield and for 2 year money the yield to maturity is minus 0.6%! Ten year bunds yield -0.07%, which is a lot of duration risk for no return. Japanese JGBs are yielding -0.10% and you pay the Swiss Government 0.45% for the privilege of owning their bonds! French 10 year OATS yield around 0.30% and you have to start taking on a fair bit of economic/political risk by going into the periphery to pick up just over 1% on Spanish long dated bonds and around 2.5% on the Italian BTPs, which of course rather blew up investors last summer. Credit opportunities are possibly a better option in Europe with spreads wider than last year and arguably lower default risk than in the US market.
  • The case for investing in bonds rests on a combination of ‘risk-off’ protection, some narrowing of credit spreads and coupon clipping. Last year’s negative returns were the result of higher US interest rates and in the last quarter the perception that a rapidly slowing economy would weaken the credit environment, leading to a significant widening in spreads. Going forward, the rate environment is more benign, spreads offer better value and the US economy has not fallen off a cliff after all. Total returns have been pretty decent this quarter which after last year’s nadir this feels rather comforting.
  • One of the features of the quarter, and March in particular, has been the strength of index-linked Gilts. This may appear surprising given that inflationary expectations remain muted but the reason is that in a quarter of falling yields, investors have been paid for holding long duration and linkers are the longest duration bonds of the lot. Conventional UK Gilts have an average duration of around 9 years, for linkers it is closer to 25 years!
  • A niggling doubt about bond markets remains the quality of corporate credit, especially in the US where both the huge quantity and increasingly lower quality of debt issuance over the last few years is a concern. Half the investment grade corporate bond paper is made up of BBB debt, the lowest level before it becomes what is euphemistically called High Yield these days but what in my day used to be called junk. The value of the BBB segment has increased by fivefold in the last decade! Canaries and coalmines?
  • One of the (many) surprises regarding the dreaded Brexit has been the benign reaction of the UK Gilt market to the roller coaster ride of the great political drama of our age. Fundamentals are supportive; the public finances are in increasingly good order so new bond issuance will be lower than expected, whilst following the financial crisis the banks and insurers hold more bonds for capital adequacy reasons than previously. Maybe as well, global investors have more faith in dear old blighty than our panicking politicians.

Summary: The sharply slowing global economy and a far more dovish stance from the US provides a benign backdrop for bond yields. Add in the benefits of ‘risk-off’ protection, coupon clipping and the prospect of some further narrowing of credit spreads then the outcome for fixed income funds certainly looks far healthier than last year.

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