Per definition bond investing has a long-term calling
The title of this outlook letter leaves no doubt on its purpose. Today, more than ever, the urge to forecast the nearby future with conviction has reached new levels. But honestly such exercise is effectively futile for professional bond investors. Week in, week out, we peruse multiple yield curves across government and corporate issuers. Constructing robust bond portfolios is our duty. Bond portfolios that assume term, credit and liquidity risks. Term risk encompasses the risk related to near-cash holdings up to investments with maturities of 30-years or even longer. That reality does not marry well with the eagerness to predict what the next 12 months will bring us. In this letter we will inform you on what consensus predicts as well as what markets price 12 months forward. However, the focus rests on our medium and longer-term assessments.
2020
In its long history, our investment community has never encountered a set of conditions like the ones presented end of 2020. Central banks across developed markets (DM) adopted zero to negative interest rate policies over March alongside the roll-out of extremely aggressive large-scale asset purchase programs. Their objective was to backstop crumbling financial markets that became dysfunctional. Essentially, it came down to market makers, whose trading books ballooned, inability to clear risk themselves as real and speculative money tried to offload traditional or speculative exposures. So central banks threw a savings line to sell-side actors. Central banks hit target in a matter of weeks and secondary markets relaxed. Primary markets reopened swiftly as the FED released a series of support programs across money market, government and mortgage-backed securities up to investment grade (IG) and high yield (HY) credit sectors. Since then, financial markets have never looked back. Financial conditions improved at the speed of light across public companies. Moral hazard saw an epic victory. The dichotomy has reached maximum tension, considering the ease by which governments and large companies roll over debt in public markets versus the availability of funds for small and medium enterprises. Yes, governments came to the rescue of large as well as medium and small enterprises. However, the latter only received interest payment holidays or loan guarantees by governments. Banks were given a free pass on their loan books. The moment governments halt those support programs for small to medium enterprises, economic growth might double dip.
In order to backstop demand, governments also provided pay checks to workers that were forced into technical unemployment. Notwithstanding this global policy response, output levels dropped between 5% to 10% over 2020. Mid-2020 predictions were even worse, but innovative and creative business owners have dampened the impact. The COVID-19 pandemic is still raging across the EU and the US. In Asia the recovery has progressed well as a result of successful corona virus containment measures. The discovery of a series of effective vaccines in November has driven markets to price normality over 2021. We expect that disappointment is close by. This COVID-19 pandemic is characterised by multiple waves. In Europe it seems difficult to contain this second wave and a third wave is developing. Expect difficult economic conditions to persist over H1 2021. Expect a protracted recovery as the pandemic has altered human behaviour. Our consumption patterns changed, our investor focus changed and even more profoundly, we changed the manner in which we spend our free time. Traveling and hospitality might be two of the sectors where the outlook remains highly obscure. Time will tell.
Regime shift
Between 2009 and 2019 bond markets thrived on the dominance of monetary policy. 2020 will have been the pivotal year that propelled a genuine cooperative and collaborative model between fiscal and monetary policy. A pre-condition for this model to work is monetary policy visibility that is given to the leading political classes as owners of the spending function. The term coined by central banks is enforced forward guidance. This means that official policy rates will remain at current levels, or lower, over the medium term. In the US, markets predict that FED policy rates will be tightened a first time around H1 2024. But even more interesting, the path of policy rates only gets us to 1.50% by the end of the decade. In Europe, it is even more protracted. Markets predict that the deposit rate facility, currently at -50bp, will rise towards -40bp by the end of 2025, early 2026. We might barely make it to 0.00% by the 2029-2030. This is the combined knowledge across professional investors reflected over the next 10 years on the path of policy rates by the FED and the ECB. As fiscal policy initiatives have added between 15% to 20% onto global indebtedness these same government administrations require funding levels to remain cheap for long. Instead of the “low for longer in rates” mantra we should change that into “low funding cost for longer” pointing in the direction of governments. Indeed, the balance of power is changing. Monetary policy will be conducted in support of, hopefully, responsible fiscal policy. I always tell people here to look out of the window and take a moment to reflect on such conditions. What do they mean? How will they impact the behaviour of agents within financial markets in general, and valuations across public and private markets specifically.
With static policy rates for the foreseeable future we have become more confident in the continued growth of central banks’ balance sheets. Last week, the ECB decided to increase its ‘temporary’ pandemic emergency purchase program by another EUR 500 billion. It will run until March 2022. They informed us that temporary will morph into permanent. Next week, expect a similar message from the FED. The jury is out whether they will increase the monthly purchase amount of USD 120 billion, or decide to buy fewer T-Bills but longer dated Treasuries. Both will lead to similar outcomes i.e. balance sheets will continue to grow. The FED, the ECB, central banks of the UK, Japan, Australia, New Zealand, Canada, Sweden…. the list is long. In addition, central banks of emerging economies have, or will adopt similar strategies. The Bank of China is leading in this space. The unconventional becomes conventional. The modal condition, so to speak, is to expect central bank balance sheet growth. Central banks will continue to absorb duration risk. Again, this requires another moment of pause, because we see that central banks acquire more of the outstanding stock of government or corporate bonds as times goes by. The free float is falling. The stock effect dominates the flow effect. However, the flow argument is often the reason why market participants expect long-term rates to rise. Japan is our inspiration. The Japanese central bank adopted explicit yield curve control back in 2016. But more importantly, as a result of continuous asset purchases in Japanese government bonds (JGB) they own more than 50% of the JGB stock. That killed the JGB market. The moment their stock control became dominant 10-year JGBs stood at 0.00%. We guess they will remain around such levels for years to come. The flow argument loses out with or without large scale asset purchases, as free markets have given up. It is quite possible that 10-year Bund or even 10-year US rates might undergo a similar fate. This brings us with market expectations end of 2021, but, more importantly, longer-term market pricing for above key reference rates.
DM & EM Rates
We described the implicit yield curve control mechanism in above paragraphs. The current jockey stick yield curves across DM reflect a condition that sees policy rates anchored till 2024-2026, whilst allowing term risk premia pushing up long rates. These term premia reward an investor for current, expected and unexpected inflation. One can add some credit and liquidity risks by picking certain EMU countries or certain sectors like inflation linked government issues. Let’s focus on 10-year bunds and 10-year US Treasuries. Bloomberg consensus forecast put 10-year bunds at -0.33% end of 2021. US 10-year rates would finish 2021 at 1.23%. When we take 1-year forwards we arrive at -0.55% and +1.09% respectively. Market participants have always, always, predicted higher rates 1-year forward over the past decades. One would almost think about conspiracy theories that would steer investors away from bond investments towards the proven higher return risky sectors of the marketplace… Anyway, 2021 predictions are no surprise.
Today, mid-December, we reflect on the 10-year German bund rate 5 year forward. This gives a level of -0.27%. In US Treasuries we pencil in a level of 1.72% for 10-year Treasuries in 5 years’ time. Investing in 10-year bunds or Treasuries today we are OK in terms of total return as long as these 10-year rates remain below the above-mentioned levels by December 2025. Given our high confidence outlook on FED and ECB policy rates, global bond investors should not be that pessimistic on current capital preservation potential offered by the government bond sectors within the EMU or the US. Within EMU government bonds we expect continued intra-EMU rate convergence. Rating agencies might play a central role in this, as they will integrate EU funding capacity into national government funding profile strength. This will frontload positive rating migration across Southern European markets. We expect to revisit a 2005 government rates valuation condition across EMU or EU member states over the medium term. Over 2021, the empowered and flexible ECB purchase program will generate an aggregate net negative supply in EMU government debt. We can only hope that positive business cycle dynamics exert upward rate pressure and raise expected returns in EMU government bonds. EMU government bonds, considering negative index yield but positive roll-down returns, provide an investor with an expected annualised return of around 0.30% over an investment horizon of approximately 8 years. In nominal US Treasuries this expected USD return sits at an annualised 1.20% over an investment horizon of 7.5 years.
Above expected returns might be lifted when considering investment in real instead of nominal rates. Since April, the global policy response has pushed up market-based inflation expectations to levels concurrent with a pre-pandemic world. We expect that increased government regulation and control, climate-related transition costs and supply chain disruption will pull inflation higher. On average, higher inflation, compared to the past 10 years, will become part of the solution mix. The FED has, officially, embedded Flexible Average Inflation Targeting into their monetary policy strategy. As a result, 5Y5Y forward inflation expectations have risen towards 2.25% today. Don’t believe inflation scare-mongers. We should prepare for 2.5% to 3.5% inflation prints over the next 5 years. This will not trigger central banks to tighten policy rates. Given implicit nominal yield curve control, it will push long real rates deeper into negative territory. In Europe, on official expectations of headline inflation of 1.4% by 2023, the 2% inflation target seems like a long-term dream. More financial repression might be part of the answer, in order to direct capital away from the insurance safety of government bonds towards productive public and private investments. In the meantime, EUR 5Y5Y forward inflation has risen towards 1.25%. We expect the ECB to achieve a 1.50%-1.75% target that would allow them to perform a small victory lap.
Again, the above reality will tilt institutional investors into reconsidering their allocation to local and hard currency emerging market (EM) government bonds. From a neutral investment stance, we turned positive on EM LC government debt over September. EM central banks have reached the final stage in their accommodative rate cutting policies. The negative EMFX impact was dominant for Euro-based investors over 2020. We probably print a negative return year. However, 2021 and beyond bodes well, as we expect EMFX to stabilise and/or strengthen as a result of global reflationary efforts by monetary and fiscal authorities. Selectivity in country exposure will make or break the EM debt pocket within one’s allocation. Yes, some countries run fragile fiscal policies. Combined with less credible central bank reaction functions, one might end up in a never-ending bad story. A professional and well-diversified investment approach will separate the good from the bad EM bond investors. EM government expected returns sit at an attractive 4.5% over a 5 to 6-year investment horizon. An attractive real yield pick-up versus average DM real rates explains this opportunity.
Investment Grade and High Yield Corporate Bonds
We like to be short on IG corporate bonds. The main reason lies in the observation that the EUR 2.5 trillion universe has become an ECB policy tool. That has driven more than 40% of this growing public marketplace into negative yielding territory. With an index yield of a mere 0.25% total returns, including roll-down returns, add up to just above 0.50% annualised over a 5-year+ investment horizon. On average, this group of large companies boasts impressive interest cover ratios. However, on balance, they also grow their leverage ratios. In their quest to please equity dividend demands, balance sheets get stretched. The main questions relate to how long the ECB’s protective cover will remain in place. Common sense prioritises government funding before private corporate funding. So, taking into account an increased liquidity premium as a result of repetitive market shock episodes over the past decade, the credit risk premium buffer around 100bp against 5-year bunds is at the lower bound. Indeed, IG credit in Europe is not cheap, nor are prices at the average over the past 5 years. We are neutral on the bond sector as we wade into 2021. We are careful as well.
In European HY, we finish 2020 on a positive note. Effectively, as we mentioned a couple of times over the past months, the HY sector has made it into positive territory. Around this time, HY indices post similar returns to EUR IG of around 2.5% over 2020. For the record, that is less than half of the total returns reaped within the loathed EMU government bond sector that sits at +5.50% at the time of writing. Essentially, looking at relative potential versus the IG sector, European HY boasts an index purchase yield of 2.80%, offering a spread of around 360bp. Taking into account negative migration and historical default rates, we drop well below 2% as return expectation over an investment horizon of slightly less than 4 years. A challenging sector, as companies are allowed to survive on the back of government support programs or a less demanding investor base. Zombification is often used and mis-used as an argument pro or contra HY investing. At the end of the day, it remains a mostly-misunderstood asset class. The long-term track record, adjusted for volatility, easily beats the equity asset class. That is also a reality. A reality that never will make it into the limelight, as the marketing budgets never exceed those paid out for equity investments.
Convertible bonds
Global convertible bonds put in a stellar performance over 2020: +25%. European convertibles, a small subset of its global parent, is finishing 2020 around +6.00%. Convertibles thrive in early cycle recovery conditions. That translated in our optimistic call before last summer. For 2021 and 2022, we believe the convertible universe will flourish. The demand-supply dynamic is healthy. Such is always a necessary condition for a sector to perform well. Global convertible new issuance has grown by almost 50% this year, whereas, for European convertibles, a moderate lift prepares us for an issuance growth spurt over 2021. Companies are attracted by the low funding costs, whilst broadening their potential shareholder base in a quest to support innovative future business models or technologies. We expect at least mid-single digit returns over 2021.
