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Going deeper

Credit positions continue to deliver the goods for wealth managers. After a rocky start to the year, sterling corporate bond funds have joined government debt and rallied pretty persistently ever since the start of the second quarter.

But it’s high yield that’s really come up trumps again in 2021, returns having progressed serenely upwards once more. That’s been to the benefit of those with dedicated exposure in this space.

Most DFMs, however, prefer to tap riskier credit via strategic bond funds. The average fund in this sector is also now in the black year to date. One reason for that is these strategies’ willingness to move further along the risk scale.

The chart below shows how much exposure DFMs’ favourite strategic bond funds have to various parts of the credit spectrum:

The trend observed there is a continuation of the one we noted earlier this year: over the past six months, the average exposure to triple-B bonds – the lowest rung of investment grade debt - has fallen from 33.2 to 30.5 per cent. Conversely, the typical weighting to BB or B-rated bonds has jumped five percentage points.

It’s not just a case of swapping one for the other. Exposure to triple-C debt has also crept higher, and the proportion of unrated bonds has risen from 4.5 to 6.4 per cent. The suggestion is that more managers are going off benchmark.

That could prove an area of interest for fund selectors’ due diligence processes. But buyers will likely welcome the impulse nonetheless. Credit returns are still healthy enough, but there’s no denying the bull market for high yield is pretty long in the tooth at this point.

Challenging the narrative

The continued rally in sovereign debt, meanwhile, has got analysts pondering the causes. On Tuesday we discussed how the rise of the Delta variant in the US had got investors worried about growth again. That isn’t the only factor being cited by observers.

Another is the old saw that is ‘positioning’. Morgan Stanley’s global macro team, writing a couple of weeks back, said a short-covering rally and steepener unwinds had created a “misleading narrative” on growth.

Of equal interest is their view that the sale of Treasuries by Asian investors in March was responsible for the sell-off seen in Q1 – despite most commentators pinning that slump on improving growth forecasts.

Barclays has a different take: its global macro team think the positioning story is “too simplistic” in itself. They point out that the rally has continued for several months now.

Both Barclays and Morgan Stanley agree that the Fed’s June meeting was hawkish. But Barclays says bond bears can’t have it both ways:

If yields rallied because the Fed was too dovish (buying too many bonds), why did they keep rallying once the Fed shifted and signalled that tapering was coming?

The bank does think US inflation will prove transitory – it acknowledges some clients think certain price shifts may prove constant, but says there's enough labour market slack to avoid widespread wage rises, and thinks the relatively brief length of the Covid recession “argues against permanent changes in the US economy”.

Even so, Treasury yields are now too low for even a typical Fed cycle.

The answer, according to the team, is that the bond market thinks the terminal Fed funds rate might prove even lower than previously expected, and certainly lower than the central bank itself forecasts. They think a rate of 1.25-1.5 per cent is plausible, which means 10-year Treasuries aren’t “egregiously rich”, even at current levels. 

Waiting on rates

If the Fed produced something of a hawkish surprise last month, the European Central Bank went the other way today. It committed not to raise rates until inflation reaches 2 per cent “well ahead of the end of its projection horizon and durably for the rest of the projection horizon”.

That means inflation could move higher than the ECB's (new) 2 per cent target for a period prior to rates being raised.

That guidance is likely to be welcomed by European equities, particularly were the ECB’s counterpart across the Atlantic to start tapering its asset purchase programme in the months ahead. For UK-based investors, the likelihood of renewed euro weakness could be viewed as a cherry on top this particular cake.