With clients concerned about credit valuations, AXA Investment Managers’ Chris Iggo has stated bonds will “easily beat” inflation over the next 12 months.
The investment firm said corporate credit, in particular, looks like it is offering attractive yields despite government bond valuations coming under pressure from increased fiscal concerns.
While credit may be expensive currently, Chris Iggo, chief investment officer for core investments at AXA IM, said income returns from a bond portfolio should easily beat inflation over the coming year.
“Investors are in wait-and-see mode until the details of President-elect Donald Trump’s agenda become clearer. For now, we believe bonds look good. Credit is expensive on a few measures, but income returns from a bond portfolio should easily beat inflation over the coming year.
“Investment grade credit provides a yield of around 5.25 per cent in the US dollar market, 5.5 per cent in sterling and over 3 per cent in euros. Credit fund managers can find even better yields than these market averages, generating a healthy return outlook, dominated by income.”
Nevertheless, he said clients remain concerned around the valuation of credit markets, with spreads low despite healthy all-in yields.
“Conventionally, corporate bond yields are compared against a government bond yield of the same maturity – the ‘spread versus govies’. On this metric, US credit is extremely expensive with spreads in the bottom one percentile of this distribution of the last 10 years (using weekly observations from the ICE/Bank of America bond database).
“However, there is another way of looking at spreads, comparing corporate bond yields to the interest rate swap curve. That tells a slightly different story,” Iggo said. “Spreads are narrow, but not nearly as narrow as suggested by the spread against government bonds.”
Government bonds are cheapening, he said, with yields above the interest rate swap curve, particularly at the long end of the yield curve.
“Government bond markets are more impacted by supply and demand factors – during the period of quantitative easing, huge demand from central banks made government bonds expensive and yields were below the interest rate swap curve. Today, the fear is of excess supply as governments struggle to bring borrowing down,” he said.
The valuations of such bonds are being negatively impacted by the fiscal outlook, Iggo said. He added that it also means credit is “perhaps not as super expensive” as previously suggested.
“However, credit is not cheap with current pricing supported by good fundamentals and strong demand. At some point some investors might just think, on a relative value basis, that government bonds are sufficiently discounted to make them attractive again, relative to a forward interest rate curve that could still move lower,” he remarked.
