Long, but not wrong

Twitter output dips, markets stabilise. Or was it the central banks? And at the same time more and more of the bond market is negatively yielding. The long-end of the government bond market still has positive yields, but it is a place for “grown-ups”. Volatility can almost match that of the equity markets. It should not be overlooked. Duration is one of the key sources of return in a world where growth is being questioned and monetary policy is easing again. Mixing duration with income producing assets remains a key fixed income strategy.

All gone quiet

Markets have stabilised a bit this week. Perhaps this was because President Trump was a bit less active on Twitter during his State visit to the United Kingdom. It really is not the done-thing to be on your mobile phone in the presence of Her Majesty. Perhaps also the collective mind of the investment community paid some attention to the 75th anniversary of D-Day, an event that surely puts some of today’s political trials and tribulations into context. There was even some sign that last week’s announcement of tariffs on Mexican exports to the US could be avoided. There was also a bit of relief from the better than expected services sector purchasing manager surveys, especially in the US where the index for May came in at 56.9, slightly up from the April result. The euro area services index was also a little higher as was, marginally, the UK index.

Easy does it

Perhaps as important as all the above was the more dovish set of signals from the Federal Reserve (Fed) and the European Central Bank (ECB). Comments from Fed officials indicated that there is an openness to reducing interest rates if necessary. On this side of the Atlantic, the ECB extended its forward guidance by six months and put a lot of emphasis on the positive impact on liquidity that would come from new long-term repo operations due to be introduced in September. Rates are on hold through to at least the end of the first half of 2020 and the terms of the repo were slightly easier than had previously been expected. Given where policy rates are in the Euro Area it is difficult to cut interest rates further, so easing the policy stance using the other tools available is the ECB’s preferred mode. This may change when Mario Draghi steps down, but for now the market seems reasonably satisfied with the modest shift to an easier stance. It has certainly underpinned the trend of flatter yield curves in Europe and has helped credit risk premiums pull back somewhat.

Negative yields everywhere

Away from the Fed and the ECB, the Reserve Banks of both Australia and India cut rates this week. This is reflective of where we are in the global monetary cycle. Where there is the opportunity to cut rates, there is likely to be rate cuts. Where rates are already at the effective lower bound and the scope for further reductions is limited, the emphasis will be on forward guidance and liquidity provision. Basically, where rates are above zero, they are more than likely going to move towards zero as policy markets confront the challenges of the end of a long, global expansion. Where rates are close to zero, policy makers are going to try to persuade markets that they will remain at zero for a long time. This does mean flatter yield curves and it does mean that more and more of the global stock of liquid fixed income is trading with a negative yield to maturity. A chart from Deutsche Bank published this week illustrates the fact nicely. It shows that close to $11trn of bonds trade with negative yields. This is very close to the previous peak in 2016 when global quantitative easing was in full swing. Recent momentum and the evolution of interest rate expectations suggests that this peak will be surpassed pretty soon. To put this into context, as Deutsche Bank points out, this represents around 20% of all sovereign and corporate bonds outstanding. There is a big concentration of this total in Europe.

Look at the long-end  

Take the German sovereign curve as an example. The 10-year benchmark Bund now yields -23 basis points (bps). The 30-year yields a positive 37 bps. Bonds below a maturity of 15-years are negatively yielding. So, if you want a positively yielding German government bond you have to be prepared to take on a lot of duration. The modified duration of the current benchmark 30-year German government bond is 25-years. For non-bond technical experts that means for every 10 basis point move in the yield, the price will move by roughly 2.5%. Since the yield peaked in early January it has fallen by roughly 50 bps and the price of the bond has gone up roughly 12.5%. That is amazing for a fixed income security in a world where returns are meant to be very low. But as most bond people will tell you, trading the long-end of the curve can be just as hairy as trading high yield or even equities. But in this market, having a view on the long-end is necessary if investors want to beat benchmark returns which are dragged down by the vast number of securities yielding below zero.

Effective hedge

The rise in the price of long-term government bonds has happened alongside a decline in equity prices and a widening of credit spreads. More evidence of duration being an effective hedge against weaker risk assets and, in my view, a relationship that should be embedded in any multi-sector fixed income or multi-asset portfolio. Even at the best of times it is hard to see government bonds for purely their return attractions – especially when yields are so low – but they do provide an effective hedge against negatively performing equities or corporate bond excess returns.

Duration can be a source of return 

The outlook for global growth is uncertain. There is broad agreement that growth has slowed, and downside risks have increased. Whether that turns into something more serious remains to be seen. Investors are hoping that a significantly dovish turn in the global monetary policy cycle will provide support for risk assets. If that is the case then it will still be likely that yield curves flatten further and the general level of yields falls, even when risk markets turn. In previous periods over the last decade when credit spreads have widened, risk-free yields have continued to decline once credit markets have begun to recover. This is entirely because of the relationship between easier monetary policy and forwards growth and earnings expectations. It’s the ‘buy-on-dips’ and ‘Fed-put’ mentality and it is hard to bet against it. Under this scenario, with the Fed now expected to cut interest rates twice this year, the cheapest risk-free asset is the 30-year US Treasury. Its current yield is 2.1% but if the Fed cuts rates to 1.5% over the next year – and forward pricing indicates more than a 50% chance of that coming to pass – then there is scope for 30-year Treasury yields to fall below 2.0% That suggests a total return of 6%-10% for the long-end of the US curve.

Barbell 

I very much like a bond strategy that focuses on higher income bonds at the short-end of the curve combined with a long-duration high quality exposure. Short duration high yield can provide interest returns in this market, especially after a period of spread widening. This is more so if one believes that central bank easing can stabilize risky assets and that an outright global recession can be avoided. The yield on the 1-5-year part of the US high yield market is currently above 6.5% with a duration of just 2.1 years. In Europe, the broad high yield market has a yield to worst of 4% with a duration of 3.5 years. Good credit analysis allows short duration high yield managers to have confidence in cash-flows and default risks in the market. Combined with a longer duration exposure there is a natural hedge against risk assets performing badly if the economic environment deteriorates. In a world of negatively yielding short-to-medium term government bonds, this barbell strategy of short duration high yield (including emerging market bonds) and long duration safe assets is an attractive one.

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