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STATE OF AFFAIRS
August did not stir financial markets as often had been the case in pre-COVID years. Instead, August confirmed the steady reflation visible across global financial markets since April. The global monetary and fiscal policy response continues to lift risk assets. Bond sector performances distribute quite nicely around the zero level. Below we list YtD performances across main bond indices for the US, the EU and global composites. We provide soft guidance on our investment stance across sectors.
US bond sectors:
+8.44%: YtD performance Bloomberg Barclays US Treasury Total Return Index Unhedged in USD. End of March total returns had already hit about +8.00%. Since then, the US yield curve has barely moved with 2-year rates anchored around 15bp, 5-year rates moving within the 25bp to 35bp range, 10-year rates happy within 60bp to 80bp and 30-year rates moving within 1.20% and 1.60%. The index yield sits at 0.51%. The Fed will anchor policy rates at the zero lower bound through enforced forward guidance. Asset purchase programs will continue over 2020 and 2021. Flexibility might lead to increased QE efforts as well as tilted purchases towards the longer end of the US Treasury curve in order to suppress long-term funding cost. The Jackson Hole conference essentially informed markets that the US central bank will depart from rules or outcomes based (calendar or economics) policy-setting. Cooperation between US monetary and fiscal policy will enable the US economy to achieve a proper level of employment (inclusive with respect for fair pay) alongside a sound inflation profile. The latter will allow the Fed to remain accommodative even if PCE inflation hits 2.5% or US CPI 3.00%. Average inflation targeting by the Fed essentially means a less pro-active Fed (no more taper tantrums or pre-emptive policy tightening) . Such a policy will keep short-end rates anchored and nominal rates at the long end of the US Treasury curve within current ranges. As inflation expectations have a lot more room for upside normalisation, we can expect, as a residual result, lower real US Treasury rates. Effectively, the Bloomberg Barclays US Treasury Inflation Notes Index surpassed the above index posting a YtD total return of +9.00%. More to come. We remain supportive on both sectors with a preference for US TIPS.
+6.50%: YtD performance Bloomberg Barclays US Corporate Total Return Index Unhedged in USD. In the past month of August, US IG corporates lost about 1.8% in performance as a result of continued high supply in primary markets and a less active central bank in its support for IG credit. What is less known is that this index has a fairly high duration of 8.5 years. The financial sector representing 30.5% of the index has a duration of 6.5 years. The industrial sector at 61.5% of the index has a duration of 9.2 years. The utility sector counts for 8% of the index and carries a duration of 11 years! The US IG sector offers a yield of 2.00% turning this sector into an attractive diversification alternative versus US Treasuries.
+1.61%: YTD performance Bloomberg Barclays US High Yield Total Return Index Unhedged in USD. End of July, the US High Yield sector had fully recovered from the aggressive March drawdown of 20%. With an index yield of 5.38% for a modest duration of 3.5 years, we look at a 473bp spread to the US Treasury curve. The month of August saw the second best month in terms of issuance ever. The credit easing efforts by the Fed are successful even if defaults in the sector are rising, targeting 9% to 10% of defaults over 2020. We are neutral given the correlation to a valuation-stretched US equity market.
EU bond sectors:
+2.44%: YtD performance JP Morgan GBI EMU Index Unhedged. With an index yield at 0.31% (or 31bp) for a weighted average years-to-maturity at 10.19 years and a duration of 8.52 years, the European Government Bond (EGB) sector eked out a great result so far. Thanks to ECB efforts (mainly through PEPP), intra-EMU rate convergence has been preserved. We see scope for further convergence gains over the remainder of 2020. Over 2021, markets will have to absorb each quarter between EUR 40 billion to EUR 50 billion of ERF (European Recovery Fund) supply. The presence and possible extension of the PEPP program will allow for orderly issuance without putting undue upward rate pressure.
+0.46%: YtD performance IBOXX Euro Corporates Overall Total Return Index. European IG corporate bonds had fully recovered from the 7% March sell-off by the end of July. With an index yield around 0.60%, an interest rate duration of about 5.3 years and a spread duration of 5.4 years, we expect the asset class to hold onto positive gains going into the last 4 months of 2020. Clearly the difference compared to the US IG sector lies in the duration profile. Indeed, we expect European corporates to tap the longer end of credit curves in order to lock in historically low funding levels. Demand is assured given the desertification witnessed in core government bond markets.
-1.93%: YtD performance ICE Bank of America Merrill Lynch European High Yield Index. European HY continues to recover from the 13.2% steep correction in March. August will be adding another 1.5%. As the EUR HY index offers a yield of about 3.95% for a spread of 450bp, we might expect full recovery by year-end. Such a path will require a stable risk environment. The September ECB and Fed meetings will not deter sentiment. The biggest worry lies in an undecided US Presidential election result. A gridlock outcome would shock investor sentiment. Accelerating COVID-19 infection rates and potential lockdowns have become less probable, but if encountered, these might quickly morph into global risk-off modus. Default rates in Europe are well contained and should remain below 7% over 2020.
+1.09%: YtD performance Exane Eurozone Convertible Bond Index. The EMU convertible bond market represents the sweet spot for investors over 2020. We expect this sector to continue to perform solidly as companies tap this market in search of capital that suits investors and existing shareholders alike. The equity optionality combined with bond characteristics will see rising institutional interest over the coming years.
Global bond sectors:
-0.09%: YtD performance Bloomberg Barclays Global Aggregate Total Return Index Unhedged EUR. July and August have harmed this global bond index’ performance, as USD weakness accelerated. This mega index with USD 53.7 trillion of market value offers a yield of 0.91% for a duration of 7.37 years. A YtD price return of 2.39% and a coupon return of 1.55% have been washed away by a negative 3.76% currency return. The latter explained by an important USD weight at a hefty 42.7% versus only 24.2% for the Euro. This index however sums up nicely what investors could have expected across a global diversified bond portfolio i.e. a flat return over 2020.
-9.89%: YtD performance JP Morgan GBI-EM Diversified Composite index (Local Currency) Unhedged in EUR. EM local currency government bond markets remain the main victim. As EM central banks turned extremely accommodative in the wake of DM central bank policy rate cuts and aggressive QE roll-out, emerging market currencies depreciated agressively. Effectively the Hard Currency comparator index for EM Government Bonds posts a more modest setback at -2.65% YtD. We expect improving conditions for EMFX as EM central banks are close to the end of their respective rate cutting cycles. The EM Local Currency Government Bond index offers a yield of 4.50%. Further recovery in global growth conditions and flattening of infection growth rates in EM countries should bolster a recovery in currency valuations.
+11.70%: YtD performance Bloomberg Barclays Global Convertibles Composite Total Return Unhedged EUR. Yes. The best performing bond sector has been Global Convertibles. We repeat that this sector is best placed at the early stages of recoveries. A buoyant primary market and eager interest of smart institutional investors should make the sector shine for the rest of the year.
With 2/3 of the year behind us we find comfort in the realized bond returns. However, return expectations across bond sectors have collapsed. Government bond return expectations fluctuate around 0.00% in Euroland versus about 0.50% in US Treasuries. IG credit spreads have returned to pre-COVID levels. HY credit spreads require a further 50bp to 75bp to reach pre-COVID valuations. The desertification has been fast and furious for bond investors across the globe.
Notwithstanding the above reality, fixed income products diversify investment risk and maintain their capital preservation ability. Real capital preservation will require a global portfolio construction.