This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here Nick Gartside, Head of Fixed Income for J.P. Morgan Asset Management, discusses where to find value in bonds in light of Yellen nomination.
Janet Yellen’s recent nomination as next chairman of the US Federal Reserve likely means no unusual lurches in easy-money policies from the world’s central banks in the near future. Coupled with Carney’s signature forward guidance policy – rates to be low for longer through 2016 – that leaves bond market participants in a continued search for yield.
So where are we finding value in the bond markets today? With rates set to stay extremely accommodative over an extended period of time, government bonds are the last place to allocate. We are short government bonds in favour of more attractive spread products. Three sectors we find to be the best source of value in the bond markets:
High yield debt
Signs are pointing to green in this sector of the bond market even after a long period of good returns. A number of fundamental factors are at work. Default rates are around 1%, meaning investors are well paid for the higher risk inherent to these securities with the index yielding over 6%. Also there is a favourable technical situation in that the next big wave of maturities is 2018 and onwards, so you don’t see a wall of refinancing requirements on the horizon. Recent weeks has seen issuance of high yield bonds souring, bringing new supply to the market, yet companies are still acting like good borrowers from a lender perspective in that more than 2/3 of high yield issuance is actually being used to pay down existing debt at higher rates. Finally, continued yield is ultimately what still makes high yield compelling. When you're getting 6% or more in interest payments, you can absorb some shocks to your bond's price even if market volatility picks up.
Bank debt
Banks are undergoing huge regulatory change and evolving capital structure. With risk comes opportunity. Countries where there is economic growth and progressive regulation on holding more capital look to be good hunting grounds. To manage credit risk, investors must seek the right place in the capital structure to allocate. We see opportunities in US senior banks and believe that within Europe, generally speaking, the value is to be found in the lower tier II part of the capital structure.
Emerging market debt
Needless to say it has been a tricky and incredibly volatile area of the fixed income world thus far this year, but for intrepid investors it is starting to look interesting again. Emerging markets generally are improving in credit quality yet EM returns have been virtually decimated this year. However this leads to opportunities as value is created. Yet in an environment where there will be less liquidity (thanks to normalising developed market central banks) investors must differentiate and closely monitor what a country’s current account position looks like when buying to access if they are being well compensated for the risk taken. We tend to look for a reasonably high headline yield and inflation adjusted yield. For example, local Mexico bonds and external dollar denominated debt is an allocation that we’ve added to the portfolio recently.
Meanwhile, we’re being very careful with headline duration risk and agree with bond market watchers increasingly nervous about potential loss from a possible spike in interest rates. We’ve reduced headline duration exposure back towards 1 year by removing some gilt duration exposure. We’re maintaining meanwhile some key long duration allocations to investment grade and high yield debt and securitised products.
We continue to be selective buyers of convertible bonds and are adding to that exposure for the attractive risk-adjusted yields available. We’ve also added to our holdings of duration hedged mortgage-backed securities.
