Over November and December market participants turned from 2 to 3 Fed policy hikes over 2019 towards a mere ½ a rate hike over 2019. As such market expectation jumps over our base case of 1 hike early 2019. We stick to our base case scenario of 1 hike over 2019 followed by a pause. The market leans towards a ‘No Inflation Scenario’ that would see the US Treasury curve bull flatten into 2019. Time will tell. Irrespective of yield curve volatility we assess that value returned to the US Treasury curve.
Investment Grade Bonds
The European IG corporate bond universe is maturing in style. Since the GFC of 2008 the universe has grown from € 800bn towards € 2000bn. The bond team was not surprised to see IG credit bump into a return air pocket over 2018. IG spreads started the year around 90bp to finish around 155bp. We called for prudence end of 2017.
With the ECB’s Corporate Sector Purchase Programme (CSPP) coming to a stop we observe that the impact on spreads was temporary and tilted towards the short end of credit curves. A trend reversal towards decompression between BBB and single A spreads unfolded over the year. We expect this effect to taper out over 2019 as interest in the universe returns and flows provide technical support. End of 2018 the EUR IG universe provides a yield of approx. 1.40%. An adverse move of 30bp is able to wipe out a year’s carry. Investors should take measure over an average 5 year investment horizon. Over that period, taking into account carry and average credit curve steepness the expected return builds towards a respectable 2.45%.
HY Corporate Bonds
High yield is a beta investment on economic growth. If economic growth slows down, HY spreads tend to widen. Throughout the past year the number of stressed HY credit events increased markedly. Credit selection makes or breaks HY performances. In the meantime leverage levels of European issuers remain close to historical lows, interest coverage numbers provide comfort. US HY names boast more leverage risk and carry higher sensitivity to tighter US financial conditions.
Overall, despite signs of rising company-specific credit risk, Moody’s expect default rates remain anchored between 2% to 4% over the coming years. With spreads around 500bp , investors are well compensated to weather such a scenario. Excluding the extraordinary September 2008 till September 2009 when HY spreads exploded to the upside, we arrive at an average 425bp HY spread level over the past 15 years. Current valuations lead us towards a neutral EUR HY recommendation.
Emerging Market Debt
We expect increasing real growth differentials between emerging and developed economies next to stable to decreasing inflation differentials. The negative performance drivers over 2018 might become tailwinds over 2019. The stronger USD, an upward shift in US Treasury rates and country specific stress events resulted in a subpar performance reading for the sector. However the damage was well contained and local currency EM bonds were far less exposed than hard currency EMD investments.
Our outlook for 2019 is positive. USD and US rates consolidation serve as a sound foundation. Many EM FX pairs have reached long term attractive levels. We prefer to select EM local currency bonds from governments that exhibit a high dose of ‘real politik’ as they tackle structural fiscal and social policy challenges.
Expected returns: All about starting yields
2018 proved to be a transition year when looking at performances. It was the year that fixed income sectors said goodbye to doped calendar year performance charts. Central banks have been absorbing duration for about 10 years. That era is about to end and year over year returns will fall back to expected return levels as shown below.
Carry and roll-down returns will become the main components of performance. Investors fall back on the basics in fixed income where coupon income tells the whole story and periods of capital appreciation will be left behind.
