Having been completely wrong-footed last year, 2015 began with leading commentators once again forecasting higher global government bond yields. Although somewhat nearer this year, most were not even remotely close as government yields have declined in all the main markets year to date, albeit with extreme volatility through much of the year. UK 10-year gilt yields, for example, have ranged between a low of 1.33% last January to a high of 2.19% in June, resulting in long-dated maturity’s returns being more equity-like with eight of the eleven months so far this year recording gains in excess of +/-2%.
Yields have declined in all the main markets year to date, albeit with extreme volatility
Despite high volatility 10-year yields in the US and UK are little changed year to date with German bunds the main mover following the European Central Bank’s decision to initiate an asset purchase programme. Bund yields collapsed then soared but have declined a substantial 33 basis points year to date. Shorter dated yields also collapsed, two-year bunds are currently -0.44% and indeed, yields are negative out to seven years. Conversely, the prospect of rate hikes pushed two-year yields substantially higher in the UK and particularly in the US where the yield curve is now close to a low for this cycle, with the current 125 basis points 10-2 year spread broadly half-way between the 2007 lows and 2011 peaks.
How Accurate Were 2015 Market Forecasts?
Beginning year forecasts were way off the mark principally because economic growth generally disappointed again, especially the very poor start to the year followed by third quarter recession fears. Continued oil price weakness ensured headline inflation was much weaker than expected and China and emerging markets led global recession concerns pushed US 5-year breakeven inflation rates to a 16 year low.
The ECB’s decision to introduce quantitative easing was perhaps the key event, ensuring the highest local currency bond returns in the EU periphery. For sterling and dollar investors, however, gilts and treasuries significantly outperformed in common currency, and once again currency was the key determinant of returns rather than bond yield trends.
So What are the Forecasters Saying for 2016?
With somewhat stronger economic activity, headline inflation set to rise significantly from the extremely lows of this year and expectations of US and UK central bank tightening, yields are generally predicted to rise.
Average forecasts indicate a year of fairly substantial, similar losses for all the main government bond markets of between 2% and 4%.
“Fair value” bond models indicate government yields remain expensive. It is difficult to conceive that US yields will remain close to 2.0% given the economic cycle has reached the stage of near full employment, wage and salary income is growing at 4% and the Fed is soon to embark on a tightening cycle.
Together with headline CPI inflation likely to jump from 0.2% to probably 2.0% by Q4 2016, real yields will fall again close to zero. US treasuries, of course, still offer EU and Japanese investors a considerable yield pick up, as well as the prospect of currency gains which, as was seen last year, can far outweigh the importance of yield moves.
Once again, forecasts may well prove overly optimistic but current low yields appear incompatible with expected economic and interest rate trends. It is also worth noting that many commentators favour US Treasury Inflation-Protected Securities (TIPS) over nominal bonds given likely inflation trends.
UK 10-year yields have traded within a -20 basis points to -40 basis points range below US 10-year treasuries for most of the year to date, with the correlation remaining high irrespective of differing economic conditions, a General Election, etc. This year the UK economy looks set to slow modestly but, as in the US, inflation is on the rise and the BOE could begin hiking rates in Q2 ahead of market expectations of a much later move.
Additionally, there is “Brexit” to overcome with the third quarter of 2016 a likely vote date. With UK inflation-linked having outperformed again in 2015, it holds few attractions at the current level of real rates.
Yields in the EU may well remain contained by ECB asset purchases while the Japanese bond market is effectively controlled by the Bank of Japan. When these markets will return to fair value is difficult to divine.
Corporates: A Better Return than Government Bonds?
In general, higher returns are forecast from both investment grade and high yield. The macro background is broadly supportive of credit and recent spread widening in the US was to some degree due to heavy issuance in investment grade and further weakness in energy and mining that affected investment grade but particularly high yield.
Although relatively late in the US credit cycle this phase is normally credit supportive and spreads are expected to narrow modestly. US high yield is starting with a near 6% yield premium and although defaults are expected to rise, which typically results in the market underperforming coupon, there is still scope for full year returns of 5-6%. There is limited scope for investment grade, however, given growing concerns over the deterioration in US corporate balance sheets and alongside the prospect of another year of heavy issuance. Small positive returns are forecast.
As for the EU, credit is much earlier in its cycle, monetary policy will remain highly supportive, corporate profitability is improving, only higher quality companies are re-leveraging and defaults will remain low. While absolute returns may be low, credit looks more attractive than the alternatives with EU governments of similar maturity yielding 0.0% and the three month deposit rate at -0.08%.
Liquidity Remains a Concern
A key concern for all fixed income markets and not just corporate credit is liquidity. The arguments are well rehearsed, diminished dealer balance sheets, a rapidly growing market and very few liquid bonds and, for credit generally, it is a moot point whether investor are being adequately compensated for both the liquidity risk and a more volatile environment where gap risk could occur from outsized mutual fund outflows. It is likely, however, that the higher expected returns from corporates than from governments will result in most investors remaining overweight the former until it is too late.
