Bonds: yields are back!
· End of the 10-year TINA era! Bonds are finally competitive against equities following the violent rise in bond yields in 2022.
· Long-term rates are at a 10-year high in Germany and the US. This implies i) a higher probability of positive performance in fixed income assets in 2023; ii) more attractive coupons that remunerate the carry trade and provide a safety cushion in the event of a fall in bond prices; iii) a lower risk of a further rise in bond yields; iv) a more balanced reallocation in bonds in multi-asset portfolios.
· In fixed income, we prefer:
o US government bonds (both short and intermediate maturities given the less potential for lower long-term rates since the recent selloff);
o US Investment Grade corporate bonds (both short and intermediate maturities given the recent interest rate movements - these maturities are relatively cheap historically compared with long maturities);
o Euro subordinated bonds, in particular corporate hybrids and AT1 contingent financial bonds. Favour issuers with a strong Investment Grade track record:
o Emerging Market bonds in hard currency and local currency.
End of the TINA era
From 2012 to 2016, several central banks around the world shattered markets by introducing negative policy rates to stimulate the economy and avoid a deflationary spiral. In addition, many launched a bond-buying programme to loosen their monetary policy further.
Consequently, volatility and risk were suppressed over time and one-third of bonds in the largest bond index (the Bloomberg Global Aggregate Index, which includes government and corporate bonds issued in developed and Emerging Markets) offered a negative yield at maturity.
At the time, yields were so low in fixed income products that the acronym TINA - There Is No Alternative (to Equities) – was coined and remained relevant for years.
Those days are now long gone. Negative-yielding bonds almost disappeared from the globe in January, about a decade after their appearance. The last stronghold of resistance is Japan, where few very short-dated bonds still have negative yields at maturity.
A painful transition
After years of accommodative monetary and fiscal policies, inflation emerged, forcing central banks around the world to raise interest rates at a rapid pace. The subsequent spike in interest rates, coupled with widening credit spreads, weighed heavily on bondholders. The Bloomberg Aggregate indices posted their worst performance in 2022 since inception (1999 in the eurozone and 1977 in the US) with a decline of 17.2% in the eurozone and 13.0% in the US
Beginning of the TARA era
However, rising interest rates have become good news for investors who can finally find opportunities in the fixed income market. In other words, There Are Reasonable Alternatives (TARA).
The terrible performance in 2022 is unlikely to be repeated in 2023, simply because the expected performance of long-term bonds is primarily determined by the current level of yields which are at a 10-year high in Germany and the US.
Thus, not only do the coupons of new bonds become high enough to compensate for a possible decline in the bond prices, but also, bonds become attractive again relative to Equities. The average bond yield is now higher than the dividend yield.
It therefore seems appropriate to gradually take positions in fixed income. We favour US government bonds, US Investment Grade corporate bonds, euro subordinated bonds and Emerging Market bonds.
Opportunities in US government bonds
Bond yield developments: bond yields could rise again in the first quarter, especially in the euro, as a record wave of new issuance is expected, the largest since 2012. This bond supply will essentially need to be absorbed by private investors as the European Central Bank's bond purchase programme is over, which suggests higher long-term yields in the euro area in Q1 and also in the United States due to the high correlation between the area’s interest rates (around 70%).
Change of narrative: inflation has peaked in both the euro area and the US. Inflationary risks will become less of a concern. Investors will increasingly focus on the impact of monetary tightening on economic growth (the one-year risk of recession is 60% in the US and 70% in the euro area according to economists’ consensus) and the timing of the next cut in central banks’ rates. This suggests lower long-term interest rates. Thus, after peaking in Q1, 10-year interest rates should drop and reach (in our opinion) 2.5% in Germany and 3.5% in the United States by the end of the year.
Valuation: US government bonds are cheap by historical standards. Long-term yields are at a 10-year high, which makes the carry very attractive and creates a significant safety cushion against any rise in interest rates. Indeed, a 10-year US government bond investor would lose money if the 10-year rate were to rise by 45bps in 12 months (to 4% versus the current rate of 3.5%). For the 2-year bond, a 220bp jump in 12 months, to 6.5%, would be needed for the investment to be unprofitable. Such a move seems unrealistic.
Our view: we are positive on US government bonds. Historically, Treasuries have outperformed other fixed income products during recessions. We are Positive on the short-end of the curve (4.3% average yield on 13 January for 1–3 year maturities), but also on the intermediate end, because we anticipate a drop in long-term rates (3.5% average yield as of 13 January for 7–10 year maturities). By contrast, we remain Neutral on German government bonds for the time being. We expect better entry points after the wave of new issuance in Q1.
Opportunities in US Investment Grade corporate Bonds
Strong fundamentals: fundamentals peaked last year, and the increasing momentum of credit ratings has since stalled due to the economic slowdown and tightening financial conditions. However, fundamentals remain strong. Leverage is very low. Companies have on average 3x more debt than earnings. The interest coverage ratio is declining but remains close to historical highs. Companies have nearly 9x more earnings than interest expenses.
Elevated yield: the average yield as of 12 January is 5.1%, level not seen since 2008. The investor is therefore being remunerated for holding low-risk bonds (Investment Grade). The default risk is very small. The rating agency S&P calculated that it has averaged 0.1% per year since the 80s. The historical average per credit quality is 0% for bonds rated AAA, 0.02% for AA, 0.06% for A and 0.17% for BBB.
Valuation: the average spread (126bps on 12 January) is in line with the historical average. The asset class is therefore neither expensive nor cheap. Compared to the economic cycle, the asset class is relatively cheap if we consider that we are at the end of an economic expansion phase. We expect spreads to widen due to the large number of upcoming issuance and the risk of downward earnings revisions. However, this widening is expected to remain modest as corporate fundamentals are sound and buying flows should continue. The asset class should generate positive returns mainly through carry.
Our view: we are Positive on US Investment Grade bonds. We recommend a short or close to benchmark duration (7 years) following recent interest rate moves. These maturities are also relatively cheap compared with long maturities on a historical basis. We particularly like Financials because their fundamentals are good, bond supply is likely to be reduced this year (the six largest US banks may cut new issuance by a third compared with 2022) and valuations are decent.
Opportunities in eurozone subordinated corporate bonds: corporate hybrids and AT1 contingent financial
Subordinated debt securities offer less protection than senior debt in the event of an issuer default, but more protection than equities.
Corporate hybrids are securities issued by non-financial companies. They are called hybrids because they have bond-like characteristics, such as the payment of a coupon, and also equity-like characteristics, such as the absence of a maturity date or a very long maturity with the possibility of not paying a coupon like an equity dividend.
Attractive metrics: corporate hybrids offer an average yield of 5.4% on 12 January (i.e. a 10-year high) with a low interest rate sensitivity by historical standards (3.8 years). The asset class seems fairly valued compared with history. However, it is cheap relative to the high quality cohort of High Yield corporate bonds (BB rated).
Resilience: corporate hybrids can be volatile and correlated to equity markets. They also have defensive characteristics. The asset class has a major proportion of Investment Grade issuers, three quarters of which are from non-cyclical and energy sectors. As a result, corporate hybrids hold up well in phases of slower growth.
Risks seem priced in: weaker companies and those that have received government subsidies may have to postpone coupon payments. The coupon is not lost, however, as the issuer will have to pay it when he/she is able to do so, on an accrual basis. The other risk, the extension risk (failure to redeem the bond on the first call date), has so far been quite rare outside the Real Estate sector. We expect most hybrid bonds with a call date in 2023 to be repaid this year. However, slightly less than half of the issuers may decide to refinance in other ways than reissuing a new hybrid bond in view of the unfavourable market conditions. Thus, the net bond supply should be reduced, which is a supportive factor for the asset class.
Additional Tier-1 (AT1) contingent convertible bonds are hybrid instruments issued by European financial institutions. They contain a clause requiring such bonds to be converted into common shares in the event of significant stress, e.g. when the capital ratio falls below a certain threshold or when a non-viability event occurs, such as the non-repayment of a debt at maturity. AT1 bonds generally absorb losses when its issuer is under stress, even if it continues to operate.
Strong fundamentals: European banks benefit from higher interest rates. Their revenues and earnings were better than expected in Q4 2022. Non-performing loans from eurozone banks continued to decline, reaching 1.8% in Q3 2022. Banks are well capitalised, with an average Common Equity Tier 1 (CET1) ratio of 14.7% in Q3 2022.
Supply: technicals are supportive as AT1 supply is expected to be relatively limited, and mostly come from refinancing this year.
Elevated Yield: 8.4% average yield as at 12 January, higher than High Yield debt (7.5%) for lower volatility and identical sensitivity to interest rates.
Manageable risks: with respect to extension risk, AT1 repayment at the first call date remains the norm. UBS, for example, respected this market convention last year even though this decision was not to its economic advantage. But the aim was not to upset investors who would have demanded a higher yield the day UBS wanted to issue a new AT1. However, smaller players (Raiffeisen and Banco Sabadell) did not comply with this market convention last year as they were unable to reissue an AT1 at a reasonable cost. Another risk is the forced conversion of the bond into shares in the event of a trigger event. This risk seems low as banks are on average well capitalised. Finally, the third risk is the non-payment of the coupon. However, it does not trigger a default procedure for AT1.
Opportunities in Emerging Market bonds
Improving sentiment: most of the risks in Emerging Market bonds (inflation, monetary policy, geopolitics etc.), are well known and priced in by the market. Sentiment on the asset class is improving since inflation is easing, the US Federal Reserve has slowed its pace of monetary tightening and China has decided to abandon its ‘zero Covid’ policy.
Better growth: December activity indicators were up on average in Emerging Markets while they slowed in developed countries. For 2023 and 2024, we expect economic growth to be stronger in Emerging Markets than in Developed Markets. More growth is a supportive factor for credit spreads.
Central banks are close to a pivot: Emerging Market central banks responded quickly to rising inflation, well ahead of developed countries’ central banks. They are therefore in a more favourable position, with positive real rates on average. Some are close to their end-of-cycle rate, while others have already reached it and will therefore be able to stimulate their economy with key interest rate cuts.
Dollar peaks: the US dollar could weaken due to the risk of a recession in the US and the end of the Fed’s rate hike cycle. A weaker dollar makes hard currency bonds and local currency bonds hedged against currency risk cheaper to issue. This implies a lower default rate than in 2022 (a year also negatively impacted by defaults in Russia and property developers in China) for EM hard currency bonds, and a better performance for local currency bonds. In addition, EM currencies, on average, are undervalued compared to their long-term average.
Elevated Yields: the average yield to maturity is 7.5% for Emerging Market hard currency bonds (JPM EMBI Global Index) and 6.6% for local currency bonds (in JPM GBI EM Global Diversified Composite Index).