Fast forward six years, and markets are finally contemplating the possibility that both central banks may soon start raising interest rates from these historically low levels. With strong data from both economies, and outspoken central bankers anticipating an interest rate rise in the first half of next year, markets have had plenty of warning signals and time to prepare.
The normal response of fixed income markets to policy tightening like this would be falling bond prices and rising yields. Government bond yields should rise the most, but – assuming rate rises come in response to strengthening economics – investment grade credit yields should rise a little less than this, and high yield a little less still. In reality, though, while credit has indeed weakened, especially high yield and emerging market debt, investment grade bonds are largely unchanged, and government bonds have actually rallied. Investors, it seems, are pricing in a very modest tightening cycle.
This is perplexing, particularly for the perpetual bond bears predicting poor performance across fixed income assets. While incoming policy tightening was expected to cause higher government bond yields, predictions of a large correction to corporate bonds are based more on liquidity, or lack of it. Indeed, market makers are no longer prepared to absorb selling. Since the financial crisis, there are far fewer traders, the capital cost of holding positions is far greater, and risk limits are far tighter, but the market is far, far bigger. This has certainly been a factor behind the moves in the US high yield market this quarter (the yield on the Bank of America Merrill Lynch US High Yield Index rose from 5.2 per cent at the end of June to 6.2 per cent at the end of September this year). Poor liquidity may also account for some oversized movements in some specific investment grade credit. For example, despite a management team determined to maintain an investment grade rating, Tesco’s well-publicised woes have seen spreads (relative to government bonds) on their 2023 bond widen from 135bps to 235bps this quarter.
Debt levels in the developed world are higher than ever before, and after unprecedented monetary stimulus, markets are right to be uncertain.
There is understandable scepticism over the Fed’s predictions for growth after years of false optimism. Meanwhile, the European Central Bank is belatedly embarking on a further quantitative easing programme, just as the US and UK look to end their own. The long-term consequences of the ECB’s decision to take short rates negative remain far from clear, but the immediate impact on European bond markets has been to crush yields.
The spread between US 10-year Treasury yields and German Bunds is higher than at any time since 1989; for UK gilts, the spread has not been higher since the BoE was given independence in 1997. It is likely that the ECB’s actions will depress yields around the globe as investors move money in search of yield. There might well be periods when yields rise and bond markets suffer temporary periods of illiquidity and volatility, as the Fed and the BoE tighten their monetary policies, but these can also offer entry opportunities. There are a number of different sectors within the fixed income asset class that I believe offer attractive valuations and can be combined to give a diversified and balanced portfolio to negotiate the uncertainty of the months ahead.
In anticipation of likely rises in interest rates, some managers invest in a number of funds which target specific short duration or floating rate high-yield sectors of the bond market. Some simply invest in short maturity or floating rate high-yield bonds, while other more specialist opportunities arise from the stricter supervision and changing regulations of the banking sector.
After the financial crisis, banks have been forced sellers of asset-backed securities, and leveraged loans. Both sectors offer high yields and low interest rate sensitivity (because the interest rate resets every few months). Specialist funds have been launched to buy up these assets and distribute them to the wider bond investment community.
While floating interest rate products are somewhat insulated from rising rates, they are also linked to the extremely low level of current rates. I expect the next cycle of interest rates to rise to peak at much lower rates than in earlier periods, and Europe’s poor economic outlook to suppress long rates elsewhere. I am therefore willing to accept duration risk, to increase and protect the yield on portfolios. I believe the demand from pension funds will also support the long end (that is, maturities of greater than one year) of the corporate bond market in the UK and continental Europe.
I know that clients are looking for an attractive yield while also preserving capital. I believe that maintaining cautious exposure to select areas of the fixed interest asset class is an invaluable means of protecting future income requirements.
John Godley is head of fixed income of Sarasin & Partners
Key points
Markets are finally contemplating the possibility that both central banks may soon start raising interest rates from these historically low levels
Investment grade bonds are largely unchanged, and government bonds have actually rallied
Since the crisis, banks have been forced sellers of asset-backed securities and leveraged loans.
