With interest rates and bond yields near all-time lows, it should be no surprise that bonds look expensive in absolute terms. We know from history that a low starting yield can have a sizeable impact on future return expectations, and our valuation framework supports this notion.
Developed Market Bonds: Low Conviction
Government bonds in the UK, Europe and Japan are significantly overvalued with many yields below or just above zero. US government bonds, while offering better value, are also considered expensive, according to our analysis.
This view comes from investors being forced to accept lower yields and longer duration—a poor trade-off – than what they have been faced with historically. With yields still close to all-time lows, this reduces future income whilst also increasing the risk of capital loss should bond yields rise towards their longer-term fair value.
The risk of this happening is growing, in our view, as the actions of central banks that have for so long been a tailwind for bond investors could well turn into a substantial headwind. Most notable in this regard is recent rhetoric from the U.S Federal Reserve confirming that it will begin to unwind the stimulus program that has provided support to equity and bond markets since the 2007 to 2009 financial crisis, while the European Central Bank has made similar overtures suggesting that it too remains on the path to more ‘normal’ monetary policy.
Emerging Market Bonds: Medium Conviction
Emerging market spreads have continued to fall over the course of 2017, meaning that investors are happy to accept a lower yield to invest in this type of security. This is perhaps surprising, as the election of Trump was thought to see credit spreads increase given uncertainty around what impact his protectionist policies may have on emerging market economies.
As such, the class is less attractive in both an absolute and relative sense, notwithstanding that it continues to offer a superior reward for risk, compared to developed world peers.
Opportunities across emerging markets are diverse, and we currently see the best opportunities in local-currency emerging market debt, whereby the bonds are issued in the currency of the emerging market nation, instead of in US dollars. Having said that, country and currency selection is vital. Hard currency – US dollar denominated – emerging market debt is also reasonably priced, but relatively less so, as spreads and the total yields on offer look much less attractive relative to historic levels.
Investment Grade Credit: Low Conviction
Investment-grade credit markets in the US, UK and Europe are expensive in absolute terms, with their current low coupons not adequate compensation for the risk of material capital losses that may come about with the normalisation of interest rates, inflation expectations and the default cycle.
Of note, credit spreads continue to contract. This is perhaps counter-intuitive given the high volumes of new issuance combined with government bonds now being relatively more attractive, suggesting that corporate bond spreads should increase. However, they remain unsustainably low, as investors seemingly continue to chase yields in the current low return environment and ignore potential risk.
High Yield Bonds: Low to Medium Conviction
Yields and credit spreads continue to fall in high yield credit, with stabilisation in both the oil price and global growth expectations seeing investors willing to accept a lower level of compensation to invest in these types of securities, particularly relative to early 2016. This results in lower expected returns in an absolute sense. Further, with yields in government bonds having moved higher, as investors adjust for rising interest rate and inflation expectations. The relative attractiveness of high yield credit has diminished somewhat.
Inflation-linked Bonds: Medium Conviction
With inflation-linked bonds, the value of the principal rises, or falls, with changes in inflation expectations. Current very benign inflation expectations around the world mean inflation-linked bond valuations offer an attractive longer-term opportunity to add cheap inflation protection to portfolios.
This has been somewhat tempered recently, with inflation-linked bonds adjusting to the commentary from global central banks, suggesting that we are on the road to a more ‘normal’ monetary policy environment and an expectation that Donald Trump’s big spending policies could increase inflation.
Nonetheless, expectations remain below long-term normal levels, resulting in inflation-linked bonds offering slightly better value to their nominal counterparts, in our view.
