Albert Edwards, Societe Generale’s famously gloomy analyst, has just announced that the group is rethinking its twenty year overweight position in government bonds versus global equities - as bonds increasingly show negative yields.
Even Edwards, whose central thesis has been that developed markets will be hit by a ‘wave of deflation’ from emerging markets, suggests that the yields on certain government bonds may now be too low.
Bond markets appear to be particularly pessimistic on the outlook for the global economy: around 40% of Eurozone government bonds showing a negative yield, Japan recently announced negative interest rates, and in the US and UK government bond yields are still at record lows - in spite of the US interest rate rise.
At the same time, it has almost never been easier to find yield in higher risk fixed income assets. In emerging market debt, the average yield is now around 5%, but short-dated (2 year) Brazilian government bonds pay 8%, the equivalent Russian bonds pay 11%.
There is a similar picture in high yield debt, particularly the US market. The S&P 500 US High Yield Corporate Bond index shows an average yield of over 7%, but some of the energy companies are trading with yields of 15-20%.
Two Distinct Bond Markets
Are either of these extremes justified? James Calder, head of research at City Asset Management, says that, in some ways, these valuations are merited: “The two markets are separate and distinct. The UK and US government bond markets are driven by interest rate expectations. The US is supposed to have four rate rises this year. I suspect it will only have one. The UK is unlikely to have a rate rise until next year.” In this environment, government bond yields could go even lower.
He adds: “At the same time, the US high yield market is made up of around one-third energy stocks. As the oil price collapses, these businesses are less profitable and the market could take a big hit. This also has a big impact for emerging markets. Also, emerging markets always tend to get frightened when you get rate rises in the US. The real question is whether investors are getting paid to take the risk.”
He doesn’t believe the price of higher risk fixed income, as yet, reflects the risk inherent in either emerging market debt or high yield, and is reluctant to invest in designated funds. The outlook for the energy sector certainly seems set to exert a drag for the foreseeable future. A number of the credit rating agencies have warned that high-yield defaults will rise in 2016 and 2017, as energy companies run into difficulties. Moody’s has put 120 oil and gas companies on review for downgrade.
However, there are some who believe value is emerging: James Foster, co-manager of the Artemis Monthly Distribution fund, says that the sell-off in US high yield has been overdone. He believes that parts of the market are now discounting recession, while only a measured slowdown is likely.
Chris Iggo, CIO of global fixed income at Axa Investment Managers, is also supportive of the sector, believing that while there will be casualties, the market is currently pricing in default levels last seen in 1997 and 2008.
Time to Look Again At Emerging Market Debt?
Emerging market debt is also attracting investors. The multi-asset team at Rathbones, for example, has tentatively been putting some of their funds into the sector. Iggo says that the ‘three-dimensional negative environment for emerging markets – slower China, rising US rates and low oil prices – is perhaps less of an overall concern at the moment than it was at points during 2015’. He says that the sector, selectively offers some attractive yields. BNP Paribas has also closed a long-standing underweight position in emerging market local debt.
For those not keen to commit money to the higher risk parts of the fixed income market, the solution has tended to be to hold very low weights in fixed income overall, rather than keep a weighting in developed market government bonds.
Tom Yeowart, manager of the Troy Spectrum fund, says: “At this point, where yields are at historic lows and it is difficult to know what is happening in the short-term, we are not comfortable with having a high fixed income weighting. If there is a recovery, these assets will not prove as safe as a lot of people believe and may be subject to capital losses.” Calder retains the lowest possible weighting to fixed income across his portfolios, believing that the market in aggregate does not offer a great deal of value.
The fixed income market is pricing in an extremely gloomy scenario. It may be right, but if growth shoots ahead, some ‘safe haven’ government bonds may come under considerable stress. In contract, ‘higher risk’ bonds appear to offer more margin for error. However, high risk assets will continue to be vulnerable to signs of deflation.
