Travelling around Europe and the Middle East in recent weeks has been interesting. Bond investors are worried about yield and about low returns.
Some want to give up illiquidity to boost returns, others want more aggressive active management to avoid the hit when interest rates rise, but most opt for the consensus trade of long credit/short duration, for the carry.
It has served most reasonably well in terms of total returns, and their bond portfolios look in better shape than their equity funds.
Yet the question is, where do we go from here? Will rates rise? Will credit keep performing?
There are no easy answers, but it seems uncomfortable that low volatility sits alongside low yields and the tightest credit spreads for years.
Yields are lower since the end of Q1, credit spreads are tighter and macroeconomic volatility is low. Total returns from bonds have been much better than I would have expected at the beginning of 2014 – 2.6 per cent for US Treasuries, 4.7 per cent for US investment grade credit, more than 8 per cent for European peripheral government bonds, and a solid 4 per cent plus return from high yield. Bonds have outperformed equities, with the S&P 500 index only up 1.5 per cent this year.
The rally in government bonds is reflective of weaker growth in the US in Q1, the lower outturns on inflation in many economies, and the slowdown of growth in China – which was again highlighted by the April purchasing manager indices showing very little momentum in the Chinese economy.
Furthermore, Federal Reserve chairwoman Janet Yellen has been relatively dovish and the European Central Bank has indicated it could “do something” in June in response to low inflation numbers in the euro area.
At the same time, there is growth and the recovery is steady, if not accelerating.
The weakness in US Q1 GDP is likely to be an anomaly, as other flagship economic indicators point to a much healthier second quarter – the ISM manufacturing index was at 54.9 and the economy generated 288,000 new non-farm jobs in April.
US unemployment continues to fall and there are signs that wage costs might be picking up a little. It’s no global boom, but we are not close to recession, either. Not too hot, not too cold. That has traditionally been a combination that favours credit because of the limited threat to corporate cash-flows.
Should yields be rising? Credit and high yield, as well as emerging market debt, have outperformed strong government bond markets, with spreads generally tightening as demand for yield has been very strong.
In the second scenario that we have been working with this would not have happened, because that would have been characterised by more of a risk-off environment and a negative excess return from credit and high yield – spreads widening and duration rallying.
I am not able to tell you what the trigger for a risk-off episode will be, but I worry about the general level of bond yields.
However, if growth is going to be running at close to 3 per cent for the rest of the year, the risk is that the recent decline in yields becomes reversed quite quickly.
Chris Iggo is fixed income chief investment officer at Axa Investment Managers
