Earlier this year, the outlook for fixed income was not good. Fast-forward a few months and things are looking less worrying. Not for the first time, bonds are exceeding expectations – and the big bond yield breakout is nowhere to be seen.
For the bond bears to be proven right, we need more than good data. We need a significant shift in positioning, some hints inflation (wage-related in particular) is on the mend and less central bank caution. All this is still possible. And the markets are more fragile than they might otherwise appear. So what’s next for yield hunters?
10-year bond yields – only bunds are near YTD highs
A mixed outlook for eurozone government bonds
The ECB is extremely wary of choking off recovery. Stubbornly weak inflation and the encouraging economic catch-up support tighter sovereign spreads over the medium term. That said, we’re wary of further volatility in the wake of ECB pronouncements.
Playing the periphery
Peripheral spreads have proven remarkably resilient recently. We like Spanish bonds in the main, but tension over the Catalonia referendum is a small cloud on the horizon. Italian government bonds should also provide some carry and possibly even tighten in the near term.
Overweight UK gilts
A gradual deterioration of economic data, and the political uncertainty we’ve seen since June, suggest the Bank of England will continue to side with the doves, despite the less cautious rhetoric of recent days. Only another rise in inflation could lead to an early tightening, which would in turn hamper growth and keep a lid on long-term rates. With this in mind, we still like gilts.
Mind your head
The embattled President Trump’s surprise deal with the Democrats kicks the debt ceiling can down the road to December, but it could still result in a shutdown akin to that of 2013. Government bond markets tend to rally at such times as investors seek out safe havens. Don’t be too underweight Treasuries just yet – they are still a safe haven asset, and they are one of the few to come with reasonable carry.
A positive short-term outlook for credit…
We don’t see too much that could derail the credit markets in the short term. While valuations in many segments seem too rich, fundamentals still look good.
...but stay on your guard
Taking on credit risk seems fine for now, but investors should be prepared to reconsider their positions later this year. Overbought markets, heavy issuance, rising rate volatility and VIX fluctuations have been, and could again be, reasons for caution.
High yield: an option for optimists
For optimists, European high yield could still appeal even though the sector is yielding less than its US equivalent. It is also far less exposed to political risk and far less dependent on oil. That said, were government bond yields to move much higher, it could choke off demand for riskier issues.
Emerging debt to continue its rise...
Emerging bonds have performed well so far this year, and we expect further positive returns – albeit not as impressive as they have been. The crawl towards normal in developed markets should keep flows into higher-yielding assets steady.
...but credit looks expensive
However, rising rate expectations on both sides of the Atlantic would pressure hard-currency markets, and emerging credit spreads could widen in turn. What’s more, emerging corporates remain pricy – corporate spreads are more or less in line with sovereign spreads.
Finding the sweet spot
Carefully targeting the best yield opportunities may be more rewarding than banking on all bonds over the coming months. For the optimists, we see two decent options: emerging debt and European high yield. We believe the ECB will extend its purchasing programme, and will pay particular attention to the last segment (corporate bonds) it touched, keeping high-yield credit safe. The emerging debt story rests on much-improved domestic creditworthiness. However, inflows have been considerable and its exposure to the Fed is still crucial, so investors should note the downside risk.
All opinions/data sourced from Lyxor & SG Cross Asset Research teams. Opinions expressed are as at 23 August 2017. Source for charges: Lyxor ETF 18/9/17
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