Slow economic growth, low inflation and central banks accommodating policies have pressed down on bond yields worldwide in recent years.
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1 ING Investment Office Publication date: 11 April 2016 Fixed Income Outlook By Simon Wiersma, Investment Manager Slow economic growth, low inflation and central banks accommodating policies have pressed down on bond yields worldwide in recent years. It appeared that this was about to change when the US central bank, the Fed, increased its policy rate for the first time in nearly a decade in December last year. Since then, however, bond yields have continued to fall and yields on short term government bonds are negative in much of the world. What are bond investors now faced with and what they can expect in the coming quarters? Bond index returns per class (2016 to 31 March) Emerging markets debt (USD) Eurozone government bonds (EUR) US high-yield bonds (USD) Globally diversified investment-grade credits (EUR) Past performance is not a reliable indicator of future results and investors may not recover the full amount invested. The value of investments can greatly fluctuate. The performance shown is without taking into account any service fee. A service fee should be deducted from the performance. Source: Thomson Reuters Datastream, ING Investment Office, 31 March Eurozone high-yield bonds (EUR) Featured indices: US high yield (USD): BofA ML HY Master II Index, eurozone high yield: BofA ML euro high yield, emerging markets debt: J.P. Morgan EMBI Global Div. Composite (USD), investment-grade credits: Citigroup EUROBIG Corporate Index, Eurozone government bonds: Citigroup EMU GBI All Maturities Index (EUR). Source: Thomson Reuters Datastream, 31 March More and more negative interest rates Lower and lower. That is the trend of capital market rates during the past 35 years. This downward trend was reinforced after the financial crisis in 2008/2009. Since then, the world has been characterized by moderate economic growth, and many regions are witnessing ever lower inflation or even deflation (negative inflation). Low capital market rates are suited to such circumstances. A rule of thumb for the interest rate on ten-year government bonds is: interest rate = economic growth + inflation. Interest rates come under further pressure from the very expansionary monetary policies pursued by the most important central banks to boost economic growth and inflation. In addition, thanks to the very low interest rates, there is still considerable Fixed Income Outlook 11 April
2 demand for government bonds due to the tighter regulations for pension funds and insurers. As a result, already more than $7,000 billion in global government bonds offer effective yields below zero. In Europe, up to a (remaining) term of seven years, there are hardly any government securities with a positive yield to be found. We have therefore moved from Zero Interest-Rate Policy (ZIRP) to NIRP (Negative Interest-Rate Policy). Interest rates low for longer... Since the beginning of this year, German 10-year yields fell from 0.63% to 0.15% and this is therefore approaching the historic low of April last year (0.07%). And despite the increased policy rates of the Fed at the end of last year, the US 10-year yield also fell in the first quarter: from 2.27% to 1.77%. The prices of eurozone government bonds have risen and produced a positive return of 3.4% in the first three months of this year (Citigroup EMU Government Bond Index). We expect that bond yields will still remain low for some time as we are not expecting a strong upturn in economic growth and inflationary pressure will remain limited. However, we also predict no substantial drops in interest rates from the current historically low levels.... but slightly higher at the end of this year We consider it likely that we will see some upward pressure on interest rates during the course of this year, and thus slightly lower government bond prices. Our most important argument for this is that pressure on inflation will increase in the US due to further strengthening of the labour market. Furthermore, following the enormous decrease in recent months, commodity prices, including the price of oil, may stabilise as a result of a slight increase in the growth of the Chinese economy. US capital market rates may therefore rise a little and pull up interest rates along with them in the rest of the world. The expansion of the asset purchase programme of the European Central Bank (ECB) announced in March is not expected to entirely compensate for the upward movement of interest rates. We expect that the Fed will raise its policy rate one more time this year and that the US 10-year rate will increase to slightly more than 2% at the end of the year. The German 10-year interest rate is then expected to be around 0.6%. Therefore underweighting of government bonds and short duration Slightly increasing interest rates, thus accompanied by falling government bond prices, will result in a limited negative return for eurozone government bonds. We are therefore maintaining our underweight position for this class in our tactical asset allocation. But although we anticipate negative returns on 12-month government bonds at the present levels, we are still maintaining some investments in this bond category, since such bonds are the only asset class to offer protection in times of crisis or great uncertainty in the financial markets. We will, however, further reduce the interest rate sensitivity of the bonds by lowering the average residual maturity ( duration ) should we deem this to be appropriate. Within government bonds, we are still maintaining a preference for government bonds from the periphery of the eurozone (such as Spain, Italy and Ireland) for the time being. We expect that the interest rate differential with the core countries will continue to decline. High-yield corporate bonds attractive One of the best performing asset classes in 2016 up until now has been high-yield corporate bonds, also referred to as high-yield bonds (HY). In the first quarter, US HY bonds yielded a return of 3.2%, while European HY bonds yielded 1.8%. HY are strongly influenced by the development of oil prices because a significant portion of all US HY bonds are issued by oil-related companies. The sharp fall in oil prices up until mid- February has therefore had a strong negative impact on both the prices and the return of HY. Since then, however, oil prices have bounced back strongly, which has led to a sharp recovery in the price of HY. Their accompanying risk premiums ( spreads ), thus differences in interest rates in relation to safe government bonds, have fallen sharply, although they remain very attractive in our opinion. A stabilisation of commodity prices is expected to lead to fewer bankruptcies than are currently being anticipated by the market. The average effective yield on HY is still about 8%. We see more room for a HY price recovery in the coming 12 months, with an expected total return of 9% on this bond category in 2016, and are maintaining an overweight in our tactical asset allocation. Fixed Income Outlook 11 April
3 Spread development* of bond categories (%) HY HY: globally diversified high-yield corporate bonds EMD HC EMD HC: emerging market debt in hard currency IGC IGC: investment-grade credits (eurozone corporate bonds) *) Spread: risk premium in market interest rates relative to the interest rates on safe government bonds (such as German) with the same residual maturity. All spreads are related to Barclays bond indices. Source: Bloomberg, 6 April Weighting of corporate bonds reduced Just like HY, corporate bonds from first-class debtors (investment grade credits, IGC) have recorded an excellent return. The increased fear of a recession was reflected in rising spreads in the first few weeks of 2016, but these have fallen sharply since mid-february. As a result, IGC prices have recovered substantially with a yield of 2.6% in the first quarter as a result. The optimism of investors for IGC was driven by slightly better economic data from the US and China, but above all by the announcement in March of the expansion of the asset purchase programme by the ECB, which in addition to eurozone government bonds will also purchase corporate bonds from the end of the second quarter. The exact details of this programme are not yet known, but it has resulted in lower spreads, not only of ICG, but also the spreads on HY. Although we expect the spread on IGC to possibly decline a little this year, the current valuation does not offer much upside leeway. We therefore decided in March to reduce the weighting of IGC from overweight to neutral by selling our position in covered bonds. We have included covered bonds in our strategies for about five years and these have realised attractive returns. However, the current effective yield is so low (around 0.3%) that we see little upside price potential. EMD in hard currency: strong recovery... In our update of November last year we wrote that the main causes of the high volatility in emerging markets bonds (emerging markets debt, EMD) were the concerns about economic growth in China and in emerging markets in general, the threat of a rate hike by the Fed and the sharp fall in commodity prices. We also wrote that we believed the very sharp decline, particularly of bonds in local currency, was exaggerated and in some cases not commensurate with the fundamental developments. Currencies from emerging markets were still under severe pressure until mid-january, but have since recovered strongly. The most important reason for this is that the above-mentioned concerns have diminished. Thus, the fear of a hard landing (sharp slowdown, if not a recession) for the Chinese economy has faded into the background, the expectation is now that the Fed will not quickly raise its policy rate (one of the reasons why the dollar is weaker in relation to emerging market currencies) and commodity prices have recovered. Emerging market bonds in hard currency (HC) have therefore also done very well so far this year. This is mainly due to fact that capital market rates in the US, contrary to the expectations at the beginning of this year, have decreased slightly. In 2016, the J.P. Morgan EMD Index Global Diversified, comprising a basket of government bonds from emerging markets issued in USD, has achieved a return of no less than 5% (in USD to 31 March).... but EMD LC absolute winner: +11% in 1 st quarter Even better still is the performance of government bonds from emerging markets in local currency (EMD LC). Fixed Income Outlook 11 April
4 The J.P. Morgan Global Bond Index Emerging Markets, which reflects the performance of a basket of EMD LC bonds, stands at 11% in USD at the end of March 2016! This has offset some of the loss incurred last year. The most important reason for the recovery is the weakening of the US dollar against the local currencies. In addition, the spreads for this bond category declined sharply. In November, we believed that the very sharp price fall, particularly of bonds in local currency, to already be exaggerated and in some cases disproportionate to the fundamental developments. Nevertheless, despite the attractive valuation of EMD, we maintained an underweight position in our asset mix until last month in connection with the risk allocation of the overall investment strategies. In March, we increased the weighting of EMD from underweight to neutral. We expect commodity prices and currencies from emerging markets to stabilise further so that concerns about the creditworthiness, and thus risk premiums, on emerging market debt will decrease further. For 2016, we expect a return of 8% on EMD in hard currency. Indices for emerging market bonds in hard and local currencies (in USD) Past performance is not a reliable indicator of future results and investors may not recover the full amount invested. The value of investments can greatly fluctuate. The performance shown is without taking into account any service fee. A service fee should be deducted from the performance. Source: Thomson Reuters Datastream, 31 March Grey: EMD LC. Orange: EMD HC. Diversification is crucial The expectations described above could support a bond portfolio consisting only of HY and EMD bonds, but here too (expected) return and risk are inextricably bound together. Therefore, despite the low expected returns, we continue to always favour investing a significant portion of a diversified portfolio in government bonds. We therefore do this in our investment strategies. By means of an active duration policy and supplemented by bond categories with a higher expected return, we seek a return on the bond investments that is slightly higher than the return on a savings account with a close eye naturally being kept on the risks. Our current positioning can be found in the Monthly Investment Outlook. Tactical allocation: fixed-income weightings March 2016 Eurozone government bonds - = + Investment grade credits Global high yield Emerging markets debt Grey: November Orange: March Fixed Income Outlook 11 April
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