After a nice run with Treasuries and Bunds this year, bond investors will be mainly looking for opportunities among high-quality corporate bonds, says Jan Wagner…
After a nice run with Treasuries and Bunds this year, bond investors will be mainly looking for opportunities among high-quality corporate bonds, says Jan Wagner…
This year, bond investors have had plenty reason to celebrate. In the US, fears of an economic slowdown caused by a trade conflict with China prompted the Fed to cut interest rates three times. Volatility in the stock market also led investors to reallocate in favour of US Treasuries. As a result, the yield on the 10-year Treasury fell to 1.4 per cent in August from 2.6 per cent in January. Due to the inverse relationship between a bond’s yield and its price, that equals a capital gain of 13 per cent for the period.
In Europe, bond investors cheered the European Central Bank’s decision to keep its key interest rate at zero and resume quantitative easing (QE). Since September, the ECB has been buying EUR20 billion worth of investment grade (IG) government and corporate bonds each month. Prior to the QE announcement, the yield on the 10-year German Bund fell to negative 0.7 per cent in August from 0.24 per cent in January. That entailed another nice capital gain for Bund holders.
The rally in mainstream sovereign bonds seems to be waning, however. Since September, the yield on the 10-year Treasury has moved back up to 1.85 per cent, and the Bund with the same maturity has climbed to negative 0.2 per cent. Market players cite two reasons for this, namely the lack of more significant stimulus from central banks as well as a resurgent stock market. Indeed, investors are buying stocks again as fears of a recession in the US or Europe recede. Of course, a trade war between the US and China could undermine this sentiment and cause investors to once again flee to Treasuries or Bunds. Renewed stimulus from central banks may also be likely.
For the time being though, fixed income professionals expect the ECB and the Fed to remain largely passive. “Chairman Jay Powell has signalled that the Fed has done its part to support growth in the US. Any further rate cuts before 2020 would be highly unlikely,” says Christian Kopf (pictured), head of fixed income at Union Investment, a Frankfurt-based asset manager with EUR350 billion in assets. He adds: “In Europe, interest rates are either low or negative, so further rate cuts would just hurt the business of European banks while not helping the economy much.”
Given this scenario, Kopf is recommending overweighting IG corporate bonds from the euro zone and underweighting sovereign bonds from core countries of the currency union. “We see opportunities among those corporate bonds due to excess demand created by the ECB’s asset purchases and the fact that, considering the economic outlook, there is a low risk of default,” he says.
Examples include issuances from AXA, Wintershall and Santander as well as subordinated bonds from French bank BNP Paribas.
Kopf is also cautious with respect to high-yield corporate bonds, given the uncertainty about how robust the economies in the US and the euro zone will be. Union Investment is projecting that US GDP will rise by 1.6 per cent in 2020 and that of the euro zone by 0.8 per cent. The average duration of Kopf’s bond portfolio is five years currently. That portfolio has also produced a double-digit return since January.
Like Kopf, Frank Lipowski at German wealth manager Flossbach von Storch (AuM: EUR45 billion) does not expect much monetary stimulus for the moment. “What is possible is that the new ECB president Christine Lagarde uses her negotiating skills to make clear to euro zone countries like Germany that there has to be more fiscal stimulus to invigorate the economy,” says Lipowski, who manages FvS’ Bond Opportunities fund (assets: EUR1.7 billion). He adds: “If that happens, we would see more issuance of longer term Bunds and other sovereigns from the euro zone. This, in turn, would reduce some of the valuation premium in Bunds tied to their scarcity.”
Lipowski has reduced his fund’s exposure to high-yield bonds while raising exposure to IG corporates, government bonds and covered bonds with shorter maturities. Regarding longer maturities, Lipowski is not looking at high-quality corporates within the euro zone, but instead high-quality debt outside of it. “My view is that the market has already priced in the ECB’s QE programme, so high-quality corporates within the euro zone are not offering much potential,” he says. Lipowski also notes that he uses derivatives to hedge parts of the portfolio against rising yields at the long or very long end of the spectrum. The duration of FvS’ Bond Opportunities is currently 4.8 years without a hedge and 7.5 years with a hedge. And for the period January to September, the fund earned 12 per cent for its institutional investors.
To sum up then: As another rally in mainstream sovereign bonds is not on the cards, investors will mainly be looking for opportunities in IG corporate debt in 2020 both within and without the euro zone. That is of course unless the threat of a recession re-materialises.
