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STATE OF AFFAIRS
The expression ‘Boring Bonds’ refers to, among others, the arcane path leading to apparently low bond returns compared to the excitement and proven higher returns offered through equity investments. Effectively, over a 100 year plus horizon, equity investment have proven to offer an additional risk premium. Honesty requires to stress that such additional risk premium only gets crystallised when you never escape market exposure. One must be ‘in the market’ all the time. In bonds, when limiting oneself to coupon clipping under a buy and hold investment style investors might get bored. But do not be mistaken, diversified bond investments have delivered attractive risk adjusted returns over long horizons. Today, I want to reflect on a period that readers might consider relevant. As a horizon, we take the moment the Euro was launched in financial markets i.e. January 1, 1999. We also release expectations on bond returns across three different profiles, from conservative over balanced towards dynamic. As we move up the bond risk curve, the profile gets more global and currency or credit risk increases.
Looking back over the past 21 years, expressed in Euro, annual total returns stack up as follows: EMU government bonds post an annual return of 4.52%. European corporate bonds were not able to exploit the extra credit risk, and given the lack of term premium, settle with a 4.10% annualised return. European high yield (HY) bonds sit at a yearly 5.35% return under a substantially higher volatility profile compared to government bonds. MSCI EMU equity total return index posts an annualised 2.98%, pushing towards 3.55%, when taking Europe as the universe. In Euro terms, the total return of the US S&P500 index finishes at 6.78%, whereas the technology-intensive Nasdaq delivered 8.78%. The objective of the above comparison is not to debunk the superiority of equity investments over bonds. That was clearly the case for US equity but not for EU listed equity. The point I want to make is that active bond management has delivered an outstanding result over the past two decades. Savvy investors profited fully, the public at large has been kept uninformed.
Looking forward, at a time where a growing number of market observers call the end of the bond bull market, we entered into an exercise composing three diversified global bond portfolios. All portfolios are multicurrency and invest more or less in emerging government bond markets or assume various levels of investment grade (IG) or HY credit risk. For all three of them, the investment horizon spans between 6.5 to 7.5 years. The defensive profile offers a yield of 1.1% for a modest volatility target at 3.5%. Investments in Euro cover 76%, 12% assumes USD risk remaining 12% across other currencies. The balanced profile offers a yield of 2.1% and is genuinely global. Euro exposure drops to 37%, whereas the USD component rises to 25%. The remaining 38% is invested across other emerging market (EM) and developed market (DM) currencies. The balanced profile requires an allocation of 20% towards EM local currency government bonds and 14% to European HY bond sector. The volatility target sits at 5% but the overall average quality retains an A rating, as is the case for the defensive profile. The dynamic profile offers a yield of 3.8% and allocates predominantly (i.e. 67%) towards EM local currency government bonds. We add 17% European HY bonds as well as 16% to Global DM (nominal) government bonds. The average rating drops to BBB for a volatility target of 6.5%. In summary, the bond world is your oyster. Don’t become victim to financial populism that pushes a negative narrative around bond investing.
The main fear that bond investor face, is that of a sudden spike in long term interest rates materialises. Indeed, temporary spikes in core long-term rates might cause a temporary correction in bond portfolio values. Recovery is certain, given reinvestment at higher rate levels. However, the impact across risk assets might be even more important, as the low-for-longer argument is used (or misused) to explain current lofty valuation levels. The central question is not how long policy rates will remain negative or at the zero-lower bound. At this juncture, market prices a first 10 basis points (bp) hike by the ECB around the first quarter (Q1) of 2026. The deposit rate is expected to turn into positive territory by Q1 2029. The US central bank is expected to lift policy rates by the summer of 2024. That is almost an eternity for many market practitioners. So, the key question today, carrying a higher uncertainty level, is how steep yield curves might become in the face of economic recovery and higher inflation readings. My central scenario calls for limited steepening pressure over the next couple of quarters, given sustained central bank duration absorption. So, the longer the market takes to price such market risks, the higher today’s value of roll-down return. Medium term, roll-down return will be a main driver of bond returns.
Over the past week, the recovery in risk assets pushed US government rates higher. Even if economic indicators leave a lot of doubt on the quality and pace of the recovery, 10-year and 30-year Treasury rates backed up by 5bp and almost 9bp, to 0.70% and 1.49% respectively. We repeat that interest might resurface with 30-year rates, hitting 1.75%, or 5y30y steepness passing 1.50%. The 5y30y steepness indicator closed Friday at 1.20%. US TIPS (inflation-linked bonds) proved the protective alternative per excellence last week, as inflation expectations recovered nicely. 30-year break-even rates finished at 1.80%, up 7bp. Early September 1.84% highs will be targeted over Q4. 10-year inflation expectations rose 6.5bp to 1.65%. US TIPS hold onto their status as attractively valued risk-free asset over a medium to long term investment horizon.
The German bund curve did not budge an inch. The 10-year and 30-year finished at -53.6bp and -10.3bp, within one basis point of the close on Friday, 25 of September. For European investors, the EMU government bond sector is the star performing sector of 2020, pushing towards a +4.01% Year to Date (YtD) result. Highlight of the week came from a speech by ECB president Christine Lagarde, stating that the policy review might (also) lead to Flexible Average Inflation Targeting. In order to get back on a 2% inflation track, taking the European Government Debt crisis in 2011 as a starting point, we should see, on average, a 3.3% Year over Year (YoY) inflation rate till 2027. It would require a 5% YoY inflation rate in order to catch up over a three-year horizon. 10-year German inflation expectations sit at 0.67%. 5-year break-even rates read on average 0.40% inflation over the next 5 years. September printed a -0.30% YoY inflation. The gap is gigantic. We expect more efforts. If we rank policy tools, we put an increase of the PEPP (Pandemic Emergency Purchase Program) in first place. Second might be a further relaxation of long-term refinancing conditions for the EU banking system. In third place would come a further drop in the Deposit Rate Facility towards -60bp or -75bp. ECB analysis shows that the EUR 1.35 trillion PEPP program is equivalent to the effects rendered by a deposit rate between -1.50% to -2.00%. Expect Q4 ECB asset purchases to cement core long-term rates around current levels for the remainder of 2020.
Spread levels across European IG and HY sectors recovered well. The Euro Iboxx index added 25bp, pushing towards a 0.92% YtD total return. HY added 65bp reducing the YtD set-back to -2.26%. Both sectors get outsized support by central bank purchase programs. IG credit profits directly. HY credit profits indirectly. Such credit easing efforts also turn both asset classes less sensitive to underlying balance sheet currents. When accidents occur, the market quickly isolates the event and goes on with the business of the day. Risk-off ripples disappear fast, as buy-on-dip investor behaviour is omnipresent. One wonders what kind of catalyst could be truly destabilizing?
EM spreads traded on a slightly better footing over the last week. Local Currency spreads (GBI-EM), tightened 3bp to 3.83%. Hard Currency Investment Grade traded at 2.26% (-9bp). Broad Hard Currency (EMBIG) tightened 8bp to 4.47%. Sub-Saharan Africa spreads in Hard Currency tightened 7bp to 7.38%.
After seven consecutive months of negative performance, EM currencies posted a positive monthly performance in September (+0.75% in Euro terms). Jamaica Dollar (+6.6% in EUR terms), South Korean Won (+3.3%) and Taiwanese Dollar (+3.2%) were the star performers. Russian Rubble (-4.4% in EUR terms), Colombian Peso (-4.0%) and Czech Koruna (-3.9%), were the worst performing currencies. We see long term value in EM currencies, but stay prudent for the time being, as volatility is increasing going into US elections.
In South-Africa, Ace Magushule, Secretary General of the ANC, is being investigated by the Hawks (Directorate for Priority Crime Investigation) and NPA (National Prosecution Authority). If he would disappear from the centre stage, this would be a real game changer for South Africa, strengthening the position of President Ramaphosa in his fight against corruption and state capture.
The market is too complacent on the ability of low-rated countries to fund the huge deficits caused by the pandemic. That is why we stick to our high-quality, highly liquid and well-diversified portfolio.
A bond investor with a correct investment horizon, not fearful of running a diversified global bond portfolio, can expect returns between 1% and 4%. The less an investor is sensitive to potential intermediate volatility spikes and open to select value across EM government bonds as well as HY bonds, the closer the 4% expected return becomes attainable. Seeking a balanced and higher quality profile carrying an expected return above 2% requires non-Euro exposure for about 2/3 of the overall portfolio. A defensive profile settles for a yield just above 1%, whilst still pushed to accept 25% non-Euro exposure.
Miracles do not exist in financial markets. The returns delivered over the past two decades cannot be repeated. Central bank intervention has pushed the expected return envelope across global bond markets lower. However, adhering to a global portfolio construction approach, we can escape the reality of financial repression.