Bond markets — expect a pickup in volatility for bonds
Andrew Mulliner, Portfolio Manager at Janus Henderson Investors, highlights the developments in bond markets this year, explaining what he believes lies ahead, while pointing out major areas of focus in their portfolios for the rest of 2018.
Bond markets feel very different this year, what is behind this?
So far, 2018 has been a very different year to 2017. Bond yields rose dramatically, in January and February, with government bond yields in the US hitting levels not seen since 2013 and threatening to move higher still. Volatility, which had been very subdued in 2017, has picked up substantially in both bonds and equities. Credit (corporate bond) spreads have moved wider but for the most part remain well behaved.
Why the change?
A combination of positive, synchronised economic growth across much of the world, central banks in various stages of exiting extraordinarily accommodative monetary policy, and signs of a cyclical pickup in inflation. To top it off, we have had significant fiscal easing in the US, which will significantly add to the debt issuance of the US Treasury.
What do you expect from the bond markets for the rest of the year?
Our expectation is that we are probably past the point of peak growth for this year. Forward looking indicators like business surveys and some monetary indicators suggest that weaker growth lies ahead, although we expect a moderation in growth rather than anything more sinister at this point. Inflation looks set to rise further from here at the headline level given the pickup in oil prices experienced so far this year, although we expect this to moderate though time, and core measures of inflation are expected to remain well contained. This leads us to expect that central banks will continue to tighten — only gradually — and lessens our concerns for a major bond rout in 2018. That said, we do think that the pick-up in volatility is here to stay, which suggests 2018 will be a year for both opportunity and risk.
Where do you see potential sources of attractive returns given the current backdrop?
We are looking at three main thematic areas for 2018. Firstly, with the big lift higher in government bond yields and with central bank tightening increasingly priced into markets, we believe that selective government bond exposure can offer both return and diversification for broader bond and risk asset portfolios.
The second area of interest to us is floating rate credit; in particular secured loans and asset-backed securities (ABS), both of which offer reasonable spreads with lower volatility than conventional fixed rate corporate bonds.
Finally, we prefer the emerging markets (EM) to developed markets for fixed rate corporates exposure. EM credit offers more diversification within the asset class itself, and for a given issuer, tends to offer wider credit spreads for similar or better credit quality. We find the likes of US high yield particularly unattractive given the tight spreads (higher valuations), high leverage and increasingly late-cycle US economy.
Asset-backed securities (ABS): a financial security which is ‘backed’ with assets such as loans, credit card debts or leases. They give investors the opportunity to invest in a wide variety of income-generating assets.
Credit spread: The difference in the yield of corporate bonds over equivalent government bonds.
High yield: corporate bonds rated below investment grade (BBB/Baa3) by major credit rating agencies such as Standard & Poor’s (S&P) or Moody’s. The typical high yield issuer has a long-term credit rating of BB/Ba2 or lower.
Headline (inflation): an inflation figure that includes volatile items such as food and energy.
Inflation: the rate at which the prices of goods and services are rising in an economy. Consumer price index (CPI), personal consumption expenditure (PCE) and producer price (PPI) inflation are a few common measures.
Leverage: the use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets.
Late-cycle: asset performance is often driven largely by cyclical factors tied to the state of the economy. Economies and markets are cyclical and the cycles can last from a few years to nearly a decade. Generally speaking, early cycle is when the economy transitions from recession to recovery; mid-cycle is when recovery picks up speed while in the late cycle excesses typically start to build, wages start to rise and inflation begins to pick up. It is often in the late stage that investors become overconfident.
Monetary indicators: economic data that would influence central banks to change policy. Example: inflation, where a high number would result in the central bank raising interest rates.
Secured loan: a loan which is secured on assets owned by the issuer, to reduce the risk for the lender.
Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment.
Yield: The level of income on a security, typically expressed as a percentage rate.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.
Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
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