Searching for higher yields

The interest rate outlook remains challenging for fixed income investors whose base currency is Euros, Swiss francs, and Japanese yen. Domestic yields remain anchored by negative policy rates and this is not likely to change anytime soon. However, wider credit spreads in local markets and in the dollar fixed income markets do suggest marginally better returns in 2019 compared to last year. For example, emerging market dollar debt now yields 3.5% when hedged back to Euro, about 100bps higher than this time last year. Investment grade and high yield markets are also more attractive, and with the Fed on hold, FX hedging costs are not likely to go wider in the short term. Still, negative short rates are a psychological drag on investor confidence and limit expectations on returns. So the message has to be that bonds will do a bit better for European investors and that it is an asset class that is still required to protect capital, enhance returns when higher yields provide the opportunity, and to accumulate wealth through the re-investment opportunities the markets should provide.

On the road

I spent the first half of the week travelling with Nick Hayes (Head of Active Fixed Income UK) in France, Switzerland, and Italy. The most common question from investors was “How are we going to make money in European fixed income this year?” It’s a good question and a very difficult one to answer. The starting point is negative rates for Euro and Swiss franc based investors. The key policy rate of the European Central Bank (ECB) is -0.40% and the key policy rate of the Swiss National Bank (SNB) is -0.25%. This of course anchors bond yields at low levels. Risk-free 2-year government bond yields issued by the German and Swiss governments currently have a yield to maturity of -0.6% and -0.8% respectively. Currently you have to go to the 8-year maturity on the German sovereign curve to find a yield to maturity above zero and above 12-years on the Swiss curve. Despite the fact that there were positive returns in 2018 from German bunds (for maturities beyond 2-year, with the 10-15 year sector delivering a total return of 3.7%), the current yield curve in risk-free government bonds does not look exciting for investors. Many feel uncomfortable taking on a lot of duration risk for very little yield compensation.

Adding yield

Outside of German government bonds other markets provide a little more yield and this gets greater the further down the sovereign ratings scale one goes. At the 10-year benchmark level, French OATS yield 40 basis points (bps) more than German bunds. Spanish bonds yield 1.13% more and Italian BTPs yield 2.5% more than Germany. So Euro based investors can boost the yield on their bond holdings by adding peripheral government bond risk. The alternative is to add Euro credit risk. The additional spread offered by the European investment grade credit index is around 1.5% at the moment but investors have to take both additional duration and credit risk to get a yield above 2.0%. Even a BBB-rated 10-year plus maturity index only yields 2.74% - (but this is 314bps above the risk free policy rate, the equivalent of that in the US would be 290bps so arguably the Euro credit curve is a bit cheaper than the US). Adding even more credit risk by going into the high yield market adds more yield. The Euro High Yield market currently has a yield of 4.37% giving a spread over the risk-free government curve of 474 bps. Risk-free rates are super low so adding yield necessarily means adding risk in a world where growth is slowing and political risk is heightened. The good thing is, default risk remains low for the foreseeable future.

Opportunities

The important point to note is that credit markets are much more attractive than they were this time last year. The yield on Euro High Yield is over 200bps higher today than at the beginning of 2018. The investment grade index yields 55bps more and the BBB-rated sector is around 80bps more. All of this with no change in official ECB interest rates and with the risk-free rate curve having gone lower in yield. So certainly one way that European fixed income investors can generate a better return this year is by increasing their exposure to credit risk. Of course this may not be comfortable for many as there are concerns about global growth, European GDP growth has weakened and the ECB has stopped buying bonds, removing a technical tailwind that had been helpful in recent years. With overall yields still low, it does not take much of a widening in credit spreads or an increase in risk-free yields to generate negative mark-to-market returns. For Swiss based investors it is even worse given the lack of yield in local markets and the negative hedging costs of going into Euro fixed income. Yet the reality is that fixed income markets do offer higher yields and that should mean better, if still low, returns.

Italian job

In Italy the investment environment is being redefined again by what appears to be permanently higher yields on Italian government bonds (BTPs). Current yields are 1.6% at the 5-year maturity and 2.7% at the 10-year. The 10-year US Treasury yields more or less the same as BTPs but hedged back to Euro that yield falls to a negative – so even if Treasuries are safer from a sovereign credit point of view, for Italians, BTPs are much more attractive. The rise in yields since last year reflects concerns about Italy’s debt levels and its budgetary plans but for the time being the market is being supported by investors who were very happy to invest €10bn in a new 2035 bond this week. There is a lot more Italian debt to be issued this year but at current yields this may be a segment of the market that attracts a lot of money despite the fundamentals. For Italian investors it is hard to find anything that provides a higher yield than BTPs. All other European government bond yields are lower and anything in another currency, hedged back to Euro, has a lower yield than local government bonds. The exception would be US high yield and emerging market debt in USD hedged back to Euro. But even then, the yield pick up to BTPs is less than 100bps for what Italian investors are likely to think of as much higher risk investments. High yield European debt, of which Italian names make up around 16% of the index), is probably more attractive.

Swiss roll

This year is likely to be difficult again for investors based in a market where the local risk-free rate is still extremely low. These risk free rates continue to reflect financial repression and it seems, in the case of Switzerland for example, local investors are being punished for the sins of the rest of the world. The various crises of the last few years and the alpine country’s reputation as a safe-haven has meant that Swiss monetary policy has been geared towards keeping the currency from continuously appreciating. That has meant intervention in the currency markets on a massive scale (the SNB’s balance sheet has increased as well as the ECB’s but the Swiss were buying foreign currency rather than bonds) and super low interest rates. Swiss investors aren’t particularly enthusiastic about moving savings into other currencies because of either the cost of hedging that or the risk of losing on adverse foreign exchange movements (the currency has appreciated in most years since the financial crisis on a trade-weighted basis). All of this, unfortunately, means it is hard to meet investors’ expectations because, as Nick has pointed out in our discussions with clients, it is hard psychologically to think that the benchmark to beat is -0.25% (i.e. losing a little money). A flat return should be good, a 2% return should be amazing.

Euro rates to remain low

Things would be better if rates were not negative in much of Europe. Sadly there is not much chance of the situation changing this year. The global growth outlook has deteriorated. Inflation remains below the ECB’s target. The ECB is unlikely to want to risk a stronger Euro in a period where US rates might have peaked and investors are less bullish on the dollar. However, I do believe things are better than they were a year ago. Credit spreads are wider in European credit markets, which at least gives higher carry opportunities with the potential for some capital accumulation should spreads narrow again later in the year. Hedged dollar yields are also higher than a year ago and the cost of hedging is not likely to go up much more with the Fed on hold for the time being. US high yield and emerging market yields rose sharply at the end of last year and, despite having come back down very quickly in the first couple of weeks of 2019, they are much higher than they were a year ago. This is good for carry and good for potential enhancement of returns should investors turn more bullish on risk markets.

Favour higher yield sectors

There is no easy answer for our fixed income investing friends in Europe. The reality is that the risk-free rate is low and that anchors yields on high quality assets at low levels. So expectations have to be kept in check but returns can be positive this year if investors do take a diversified risk approach. There are some interesting global opportunities in bond markets. The recovery in emerging market debt is genuine in our view even if there are still concerns about President Trump’s trade policies and the slowdown in China. Our US high yield team does not envisage a big increase in corporate defaults as long as the US economy avoids recession, and even investment grade bonds in many markets are starting to trade with attractive yield levels again. I did not come back from Switzerland feeling that investors were itching to add risk (quite the contrary with many still reeling from a difficult 2018) but it may be that markets surprise to the upside for many of them. Stable US rates, an ECB that might add some stimulus in a post-QE world with another long-term repo operation, the potential for some fiscal stimulus and the possibility that there is a trade deal, a re-opening of the US government and that the worst case Brexit is avoided might all re-invigorate risk assets and a more optimistic economic view. I don’t know whether that is a bit rose-tinted but what I would say is that the view for this year should not be tainted by what happened in 2018, especially in the last few weeks of the year.

Diversification

It is worth also saying at this stage that yield is not everything. I have mentioned before that the lowest yielding asset class (bunds) was one of the best performing. Demand for low yielding risk-free assets is clearly not driven by yield but by the need that investors have to hedge the risk in their portfolios. In the last quarter of the year, US high yield saw a mark-to-market loss of -4.7%. At the same time an index of Treasuries had a +2.6% return. Risk and duration are negatively correlated, especially in extreme market conditions. That is why having duration through long-dated low yielding government bonds, alongside high yield and emerging market credit risk, is a strong proposition. The role of bonds in any portfolio is to protect capital, enhance returns through buying cheaper credit assets when appropriate, and accumulate returns through re-investing income. This year offers better opportunities on all three of these than was the case in the last couple of years.

I’d love it…

The Premier League is Liverpool’s to lose and they are probably rightly 4/5 on to be champions in the betting markets. However, the second half of the season is going to be very interesting given Manchester City are hot on the heels of Liverpool and there will be an interesting battle for the remaining two places in the top four. If I was analyzing Manchester United using the framework we use for assessing bond markets, I would say that the “macro” factor is improving with better management and a more motivated squad, the “valuation” factor is also improving given that the team is likely to amass more points and goals in the second half of the season than it did under Jose, the “sentiment” factor is clearly up from a few weeks ago, and “technicals” are positive in that there are no serious injuries and there is the potential for adding to the squad in the current transfer window. A win against Brighton tomorrow would mark seven victories in a row for Ole, without any need for spying.

Have a great weekend,

Chris

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