Pockets of yield despite record-low interest rates

With interest rates at records lows, and even negative in some cases, advisers could still find some yield and diversification if they look outside traditional sovereign bonds.

At the time of writing, developed market bonds were at record lows such as Australian 10-year government bonds at 1.01%, US 10-year bonds at 1.69%, and German 10-year bunds at -0.46%. 

In August, US two and 10-year Treasury yields inverted for the first time in over a decade, signalling a looming recession, and indicating bond yields would not increase anytime soon.

However, according to Bank of America Merrill Lynch’s latest data, bonds globally had US$11.1 billion ($16.4 billion) in inflows over the year to September, 2019.

Fidelity’s latest investment outlook said the ongoing trade war between the US and China, and weak economic data, had spurred investors to seek out safe havens such as government bonds and gold. 

Other macro events like Brexit had caused Gilt yields to rise and beyond that the UK could be set to plunge into a technical recession, while the European Central Bank’s announcement of a new round of quantitative easing would widen spreads between semi-core countries and Germany, Fidelity said.

JP Morgan Asset Management’s chief investment officer of the global fixed income, currency and commodities group, Bob Michele, said the biggest problems in terms of finding yield were in Japan and Europe as central banks were concerned that these economies had the potential to roll into a recession. 

“Some of the data that has come out of Europe is horrible particularly on the manufacturing side and especially purchasing managers surveys as they don’t look good,” he said.

“In Japan they have been trying for decades to generate stronger growth and some inflation but they are getting concerned that this far into a recovery they don’t have that yet.

In those markets the central banks are looking at the US/China trade war and concerned that ultimately that will spill over to the global economy and cause a recession.

“But these central banks are committed to keeping rates low.”

However, Michele noted that over the year to August German bunds managed to generate a positive return despite negative yields.

“Although you generate a negative return on the interest rate carry of the bond, the price appreciated because the yield continued to fall further into the negative territory and this created a positive yield. 

“Everyone is struggling with how to value that. If you’re an investor in a higher yield market you could have bought European bonds at negative yield, hedged it back to your base currency, picked up between 2-3% depending whether you were in Australia or the US and suddenly you had a positive yield.”

He said there were still many reasons to be invested in bonds as the asset class could generate positive returns in places such as the US, and in Australia, and Canada where rates cuts would continue.

“Many of the emerging market banks are also cutting rates and we think you get really high real yield there and gain some capital appreciation,” Michele said.

GETTING AWAY FROM TRADITIONAL GOVT BONDS

However, given the low yield globally, Michele said this was an opportunity to look at other bond markets such as investment grade corporate bonds, US securitised credit or mortgage-backed securities as they provided yield, diversity and had further price appreciation to come as central banks continued to cut rates.

Agreeing, Mercer head of portfolio management for delegated solutions, Ronan McCabe, said investors should look away from traditional sovereign bond markets such as absolute return bond funds as they were defensive in nature and were actively managed.

Acknowledging the downfall of large absolute return bond funds such as GAM Absolute Return Bond funds which had liquidity and cultural issues, McCabe said advisers needed to do their due diligence on managers. 

“Other than traditional credit and sovereign space advisers can also look at multi-asset credit, which have managers that are more dynamic and nimbler, high yield, emerging market debt, and certain distress debt opportunities, and investment grade,” he said.

“In the alternative less liquid space we find private debt and direct lending attractive which is a combination of investing in corporate loans, real estate debt, and infrastructure debt.”

McCabe noted that senior private debt along with infrastructure debt was also attractive. He said infrastructure debt was less liquid and had fairly defensive features. He noted that globally there was a huge pipeline of infrastructure projects in Australia, Germany, and in particular the US.

EMERGING MARKET BONDS

On emerging market debt, Fidelity said it had a positive outlook overall, backed by “the chorus of dovish global central banks and further domestic stimulus expected from China”.

It noted that it had added tactical positions in Russia, Brazil, the Philippines, and India, and was underweight in Israel and Korea.

For Colchester Global Investor’s investment officer, Martyn Simpson, advisers should look for emerging markets that did not have a currency issue and said he avoided low-yielding countries like Czech Republic, Hungary, Argentina, and Turkey. 

“The emerging market countries that have hard currency debt denominated in US dollars bonds tend to be more risky as repaying the debt is difficult. 

“These countries also have a lower credit rating quality unlike local currency debt denominated countries. In the local market the credit quality tends to be higher. The average in our benchmark is BBB which is investment grade. While there is some non-investment grade in the index, by in large the average is triple BBB,” he said.

Looking at short-term bond fund performance, FE Analytics data showed that over the year to 30 September, 2019, the top two performing funds were emerging market debt funds – Colchester Emerging Markets Bond I at 17.7% and Mercer Emerging Market Debt at 15.9%. 

These funds were followed by two high yield funds – CFS High Quality US High Yield A at 15.3% and CFS US Select High Yield A at 14.4%. Coming in fifth was GCI Diversified Income Wholesale Unhedged at 14.1%.

Chart 1: Top five bond funds performance vs ACS Fixed Interest - Global Bond sector over one year to 30 September 2019

Source: FE Analytics

Simpson said his fund had performed well and bonds had delivered two-thirds of the alpha and one-third from currency.

“If you look at our emerging market fund we use real yield as main valuation tool, and at the moment Mexico has a very attractive real yield,” he said.

“While there are a few worries with the Mexican government’s president being seen more as a left winger, if you look at the budget they’ve produced it looks relatively conservative. Inflation has been falling down to about 3.4% and we’re seeing things move in the right direction and the central bank will be able to control inflation with rates.”

When considering political worries, Simpson said he valued countries by their real bond yield but made an adjustment on that yield with the country’s financial balance sheet strength and part of that was Colchester’s environmental, social, and governance (ESG) evaluation. 

“Although there’s political risk in Mexico we tend to think that that is sometimes overstated. In the longer term most political events that seem quite big at the time tend not to be so big when you look back in six to 12 months,” he said.

INCOME BONDS OUTPERFORM BUT NOT VIABLE

Looking over the longer-term, over the three years to 30 September, 2019, three of the top five performing funds were income funds. 

The GCI Diversified Income Wholesale Unhedged fund returned 25.1%, followed by Challenger Guaranteed Income 400cents per annum at 18.9%, Mercer Emerging Markets Debt at 18.5%, Mercer Global Sovereign Bond at 15.6%, and PIMCO Income Wholesale fund at 15.1%. The global bond sector average returned 11.7%.

Michele warned that advisers should be careful around income bonds as a lot of these funds included some investment grade corporate bonds but also high yield, and emerging market debt that provided the income. 

“We’re saying migrate out of all of that into the higher quality investment grade space,” he said.

Chart 2: Top five global bond funds performance v ACS Fixed Interest - Global Bond sector over three years to 30 September 2019

Source: FE Analytics

RECESSION WORRIES

For advisers expecting a recession, Michele said to look at higher quality intermediate duration bonds as the US/China trade war was impacting corporate profitability and default rates which were around 2% could increase. 

“Current US high yield spreads is about 4% and insufficient to compensate you for default rates. We’re starting to scale out of below investment grade securities, as part of this move into the higher quality end of bond market,” he said.

He noted that if the trade war triggered a global recession then the bond market would be the beneficiary of flows coming out of corporate earnings and investors scrambling for safety as default rates rose.

McCabe said advisers who had a possible recession on their minds could tilt their portfolios towards government bonds that had a longer duration depending on how long they thought the recession would last. 

He also agreed that moving towards higher quality credit was wise along with multi-asset credit due to its defensive nature.

“A good manager will rotate different parts of the credit space and the fixed income space. They might be quite high in investment grade at this point in time and if a recession happens then lower quality fixed income securities will sell off. Then these managers will rotate portions of the portfolio into sectors they think are undervalued,” he said.

HOW TO PICK A BOND MANAGER

McCabe noted that advisers needed to make sure the bond manager’s team was experienced and had been through many different investment cycles to make sure they had outperformed the benchmark in the past. 

“You have to understand what their edge is and really find out what their philosophy is and why you should deploy capital with them. Always be mindful and careful about taking risk. You need to get paid take risk and don’t take risk for risk sake as investment is really a risk management game,” he said.

He said red flags were large staff turnover, a dramatic drop in funds under management over a short time period, and cultural issues. 

“Things like humility are important too, they should be humble and passionate about what they do, and know what their edge is and know what their edge is not, and they don’t try to be something they’re not,” McCabe said.

“They should be willing to take risk but concerned about it all the time. Good managers can minimise things that are outside of their control, and when they do take risk they make sure they get paid for that risk.”

For Simpson, finding a manager that stuck to their process and a good long-term track record was important.

“When you get to the mid to late cycle of the economic expansion, managers start to chase yield or do something different than they have in the past to produce some returns,” he said.

“This could lead to difficulties and surprises after you select the manager. What you want in a manager is one that sticks to their process they say they are going to deliver and that makes it easier to fit it into an adviser’s overall asset allocation.”
Similarly, Michele said advisers should look for funds that performed well during periods when rates were rising and falling as it indicated it was an ‘all-weather bond fund’.

“Then you have to think about what resources is the manager using. If they had a global footprint, if they have a research team, and portfolio manager in different locations around the world, and if they use that to find ideas and put them in the portfolio. Then you have to start thinking about whether there’s any bias?” he said.

“The bond market has become more difficult and yields are not going to go up anytime soon, if anything a lot lower, so it really puts a lot of pressure on bond managers to find value, generate a positive returns, and not take too much risk for clients.”