It is not often that bond markets make the news, but at the moment they are making the headlines. Neil Birrell, Premier’s Chief Investment Officer takes a look at the unprecedented state of government and corporate bond markets today and points out some of the risks of being involved.
Inverted yield curves, negative yields, tight credit spreads, real yields; these have all become jargon that are in everyday use and are hitting the front pages as well as the finance pages of the popular press. It is unsurprising the extraordinary and unprecedented bull market in bonds has captured everyone’s attention, particularly when it can be associated with the headline of “recession predicted”. In this note we will try and point out the dangers of getting dragged into this phenomena. For the purpose of full disclosure we have not been big investors in bonds, This has cost us some performance, and we remain wary of adding to positions.
Money has flooded into bonds as yields have fallen and those flows have pushed yields lower. In the US, in June alone, over US$25bn was invested into fixed income ETFs. Similarly, at home, over £2.4bn of net retail sales went into funds in IA fixed income sectors, with around £1.1bn invested into the IA Strategic Bond Sector alone. These flows should be set against a backdrop of IA equity sectors experiencing £0.5bn of net redemptions.
We believe such an investment decision is difficult to justify and that the current risk reward profile of the bond market looks stretched, particularly corporate bonds, where the spread between corporate and government debt is at historically low levels and the market seems to be priced for perfection. Should the global economy begin to deteriorate, the corporate bond market could come under significant strain as companies find themselves downgraded by ratings agencies and bond investors are forced to sell their holdings into a liquidity vacuum.
Never before has the bond market contained such large quantities of debt yielding below zero, where investors are effectively paying governments for the right to lend them money. The recent bond market rally has seen the value of negative yielding debt surpass US$16trn. The total amount of debt with a negative real yield, which trades with a yield below the rate of inflation, is worth over US$30trn. Even some corporate bonds, albeit ones issued by Nestle are trading on a negative yield. If issued by Nestle that is understandable, but Fiat, a company at the centre of geo-political and structural industry risk, has a junk bond trading at a negative yield.
To try to put a bit of colour on the potential downside we can turn to some “bond maths”. On 21 August, the German government issued 31 year bonds with a 0% coupon. They were priced at €103.61 meaning they had a negative yield of 0.125%. Is this a risk-free return or a return-free risk? The price even rose following the issue. If investors were to decide that a negative yield was not that attractive and the yield simply fell to 0.00%, this would generate a loss of 3.9% for the investor. Let’s take that a little bit further and assume that the ECB opens the taps, pumps money into the economy, the same thing happens globally and recession is avoided. In fact, the economy starts expanding again. In that environment, bond yields will rise and this one may go to 1.0% and the holder of that bond today will experience a loss of 29.4%. Imagine if the ECB conjured up policy measures that meant that it hit its own inflation target of 2.0%; this bond could move to a yield of 2.0%, which is not even a level to achieve a real yield. That investor will lose 48.0% of their money. In our view, that’s an unappealing prospect.
As you can see from the chart above the extent of the rise in the amount of negative yielding debt is unprecedented and indicates the confidence bond investors have that interest rates around the globe are due to fall. Recent central bank actions lend weight to that opinion. In one day in August, the central banks of India, Thailand and New Zealand lowered their benchmark interest rates by a magnitude that took the financial markets by surprise. This followed the first cut in interest rates by the US Federal Reserve in over a decade. Meanwhile, the spread between the two and ten year bond yields inverted for both the US and UK governments, for the first time since the global financial crisis. Yield curve inversion is often seen as a reliable indicator of an impending economic recession and in fact it has moved so far that the word depression is getting an airing by some commentators. It would appear that both government bond investors and central bankers are agreed that economic growth is heading lower and quickly.
As all bonds are priced relative to government debt, on the whole corporate bond yields have also fallen. Credit spreads which measure the difference between corporate and government bond yields have also narrowed, as investors have been forced to search for more attractive yields within the corporate bond market.
Tighter credit spreads traditionally indicate investor confidence in the prospects for the economy and the market. A company with sound fundamentals such as a strong balance sheet and the ability to keep growing its earnings can expect to be rewarded by the financial markets with a tighter credit spread, enabling it to borrow money at a lower cost. At a macroeconomic level, tighter credit spreads are usually associated with a buoyant global economy. Herein lies the problem; whilst central bank actions, government bond yields and yield curve inversions point to an imminent slowdown in global economic growth, credit spreads appear to be priced for perfection; such a situation feels unsustainable.
We are approaching the end of a business cycle that has seen a massive increase in the amount of investment grade corporate debt on the market. Much of this increase has been in debt at the lower end of the investment grade category, that is bonds with a BBB rating. Investment grade status is much sought after by companies, as such a rating allows them to raise capital at a lower cost. Ratings agencies will often require strict criteria to be maintained for a company to keep its investment grade rating. These could include metrics used to measure a company’s financial wellbeing, such as a minimum level of interest cover or net debt to EBITDA ratio.
During a period of economic weakness, businesses will come under pressure and earnings can suffer; adhering such criteria can be challenging. It is true that during a downturn central bank policy may be accommodative. Indeed, as discussed, we are currently entering another round of monetary easing. Crucially however, central bank policy has been loose for some years and interest rates are already at extraordinarily low levels, limiting their scope for action. During each of the previous two recessions, the US Federal Reserve has lowered interest rates by around 5%, but US interest rates are currently at 2.25%. At other central banks, the situation is even more extreme. The European Central Bank’s interest rate is currently zero and the Bank of England has set interest rates at 0.75%. With credit spreads at current levels, we believe there is a complacency among investors as to the efficacy of central bank policy. It is probably why we are hearing more and more governments start talking about loosening fiscal policy and reviewing austerity measures. Even Germany is being forced into such talk, as their economy leads the way towards negative growth.
Company management will undoubtedly have plans in place to maintain their credit rating when earnings begin to suffer. These will usually involve cutting dividends or selling non-core assets. However, forced deleveraging during a time of economic stress is unlikely to take place in a painless manner. Despite the best laid management plans there will inevitably be companies who find their debt downgraded. In the case of a bond that has a BBB rating, a downgrade means becoming a ‘fallen angel’ and dropping from investment grade into high yield status. When this occurs, the fall in value can be severe and much worse than that of a bond being downgraded from a higher rating down to BBB. Many bond investors have an investment grade mandate, meaning they become forced sellers whenever they hold a fallen angel, leading to an oversupply which drives down the price. During a broad economic downturn the amount of investment grade debt that is downgraded could be substantial, exacerbating the situation.
make matters even more precarious, there are serious concerns about the liquidity of the bond market and how impactful this could be during a significant sell off. Increased capital requirements have discouraged banks from participating in the bond market, with their dealers now holding fewer bonds on their books. The ability of dealers to make a market during a downturn has been called into question; indeed, during the market turmoil in the final quarter of 2018, bond market liquidity did deteriorate markedly. The fear is that during a bond sell off, there will be too few buyers in the market, leading to abrupt and extremely severe falls in bond prices.
With government bonds yielding such low or negative numbers and credit spreads seemingly detached from reality, we do not believe that bonds offer sufficient value, outside of a few niche areas. Again, for clarity, we have been wrong on this for a while, but we believe the risk and reward ratio has moved so far the wrong way that our decision not to be involved is just getting reaffirmed. Instead, we prefer to concentrate on more alternative, specialist or convertible fixed income holdings that can offer relatively attractive returns that are lowly correlated to traditional bond prices. Where we do invest in the corporate bond market, we concentrate on debt that has a shorter maturity, where the visibility and predictability of returns is stronger.
Government bond yields could well remain where they are or fall further through a downturn, but we believe corporate debt yields will not. Furthermore, if the world economy is not as bad as we all seem to think, then the downside to government bonds is considerable as well and although credit spreads may stay tight, the yields will rise.
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