The recent rise in bond yields has increased the attraction of bonds as a source of income and created a better entry point than the record low yields we have become used to in recent years. By closing some of the gap between equity and fixed income yields, the recent rise has also increased the relative attractiveness of fixed income as an asset class.
Where yields go from here will be largely dependent on the outlook for growth and inflation. While they will move slightly higher as interest rate hikes feed through, it is hard to see them rising significantly and sustainably from current levels given the presence of structural and long-term deflationary forces.
That said, there are some short-term tailwinds that will exert upward pressure in the US; cyclical inflationary impulses from higher wages; an increased supply of Treasuries; and potentially, although at the margins, trade tariffs. Here in the UK, inflation looks to have finally peaked after its post-Brexit spurt, and as prices moderate the Bank of England should be able to hold to a gradualist policy on rate increases.
Investors have typically sought exposure to fixed income for three main reasons: growth, income and diversification. Until recently, all three have historically been relatively well served by what has typically been referred to as a ‘core’ bond market exposure; a mix of developed market government and investment grade-rated corporate bonds. The last 20 or so years have seen these strategies deliver solid returns and a reasonable level of income, while also offering a hedge against risk assets, such as equities.
Recent years have been less generous however and returns and income levels from core markets have declined at the same time as correlations with equities have risen, weakening their case as a reliable hedge. And looking forward, duration, the key driver of returns as core bond yields experienced a multi-decade decline, is likely to be less prominent as yields gradually increase.
However, core fixed income still has merit, particularly for pension and insurance clients who rely on strategies with embedded duration to help manage their liabilities, which are long in nature and ultimately discounted using bond yields. It is also the case that the cash flows they offer are very appealing, especially as yields start to rise as they have done recently.
Given the expectation of lower returns from duration, additional sources of return are likely to be sought from high yield, global credit or emerging market debt, where returns are less driven by interest-rate risk and credit risk plays a more prominent role. They can also help address the belief that rising yields are universally bad for bonds. Most of the time, rates rise because the economy is picking up, so the benefit to a corporate bond issuer’s credit profile from better growth and corporate earnings can be a bigger driver of performance than rising government bond yields.
In the near-term, we are cautiously optimistic on credit. February’s spike in volatility was triggered by better economic data, high US equity valuations and crowded short trades on equity volatility index options. All things being equal, permanently higher volatility should result in higher credit spreads given this would be an indication of greater uncertainty. However, we do not expect volatility to stay high and see the volatility spike as a short-term dent to investor confidence rather than a permanent shock.
From a fundamental perspective, credit remains on an improving trend, with the strong economic backdrop providing support. Furthermore, US tax reform should prompt less issuance and some corporate deleveraging. While spreads are tight in a historical context and provide only a limited buffer against future shocks, they can tighten further should rates increase at a gradual rather than rapid pace.
Mark Munro is investment director of Aberdeen Standard Investments
