- Developed-market government debt looks more vulnerable than ever to the effects of rising rates—as do passive strategies, by extension.
- Tight valuations in the corporate debt markets suggest greater risks to the downside, although we believe select opportunities do exist.
- Currencies may continue to be whipsawed by headline risks; investors will need both patience and the capacity to react quickly as markets shift.
The gradual end of easy money won’t be an era fixed-income investors are likely to remember fondly. As the world’s central banks have slowly normalized monetary policy, the combination of rising short-term rates and the constant demand for yield—along with correspondingly tight spreads—has left many segments of the bond market vulnerable to bouts of heightened volatility. As we look out at 2019, many of the challenges investors faced over the past year are likely to persist—but that doesn’t mean investors don’t have options available for generating income in what may prove to be an unpredictable market environment.
Passive bond allocations have grown riskier
Three decades of steadily declining yields and ballooning debt issuance in developed government bond markets have left passive bond strategies particularly vulnerable to rising interest rates. Consider that since 1990, the duration of the Bloomberg Barclays Global Aggregate Bond Index (Global Agg) has increased by more than 50%, while its yield has dropped by 75%. The result is a portfolio that offers less income and is more tied to interest-rate changes than it’s ever been— and at precisely the wrong time. Today, investors in a Global Agg-like strategy can expect a decline in return of more than 4% if yields climb 100 basis points—not an insignificant loss from what would likely be intended to represent the most conservative part of an investor’s portfolio.1
Although unlikely to be as pronounced as in 2018, the chance of higher rates in 2019 remains significant, in our view. In the United States, the U.S. Federal Reserve (Fed) appears to be on track for two more interest-rate hikes in 2019, which would bring the federal funds rate to a target range of 2.75% to 3.00% by the end of the year.2 If we saw a surprise uptick in inflation and a flat—but not inverted—yield curve (which are two admittedly big assumptions), the yield on the 10-year U.S. Treasury has the potential to rise into the mid-threes by the end of 2019. That’s exactly the kind of scenario that could produce losses in a high-quality Global Agg-type strategy.
While monetary conditions in other developed markets (DM) remain looser than in the United States, the days of stimulus-driven returns in Europe and Asia are clearly behind us. Ten-year government debt in Germany and Japan continues to yield much less than 1%, and the combination of lackluster economies and little chance of declining rates driving returns paints a fairly bleak outlook for DM government debt.3
Yet that’s exactly what investors in passive allocations are buying. The Global Agg holds more than 67% in Treasury and government-related debt.2 For that reason, we believe investors need to exercise caution in 2019 when it comes to DM government debt and, by extension, passive income allocations.
Passive strategies have become increasingly vulnerable to rising rates
12-month horizon return given a 100 basis point increase in yields
Source: Bloomberg Barclays, as of September 30, 2018. The Bloomberg Barclays Global Aggregate Bond Index tracks the performance of global investment-grade debt in fixed-rate treasury, government-related, corporate, and securitized bond markets. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Valuations in corporate debt suggest downside risks
The challenges DM government debt presents aren’t easily solved with an allocation to the corporate bond markets. While the opportunity set for income-seeking investors may have diminished in the wake of the 2007/2008 global financial crisis, the need for income did not. As a result, spreads in U.S. corporates are now well below their long-term averages, both in high yield and investment grade.1
An environment of tight spreads, relatively low yields, and tightening monetary policy is hardly an ideal backdrop for making a blanket allocation to corporate debt; while we place a low probability on a global recession in 2019, high yield looks relatively vulnerable to any unforeseen economic shocks. Looking to recent history as a guide, in 2011 and 2015, spreads in the high-yield market widened out significantly as investors digested the realities of the European debt crisis and the collapse in oil prices. Should the Fed’s tightening policy lead to a slowdown in economic growth or cause the yield curve to invert—historically, a reliable leading indicator of a recession in the United States—the chance of a risk-off environment negatively affecting the high-yield market is not insignificant.
Investment-grade (IG) corporates, on the other hand, present their own challenges. Because IG corporates entail less credit risk relative to high-yield corporates, these securities tend to be more sensitive to changes in rates. While it’s notoriously difficult to forecast changes in longer-term yields, we think it’s fair to say that there are more forces aligned to push rates higher than to pull lower, at least in the United States. If that’s the case, interest rates are more likely to be a headwind than a tailwind for IG corporates in 2019.
Another variable worth watching is the BBB segment—the lowest-quality tier of the investment-grade space—which has grown from about one-third to nearly half of the IG corporate market over the past 10 years.2 Any deterioration in global economic conditions could cause a ripple effect in this space; securities downgraded to BB would trigger forced selling in passive index-oriented strategies and strictly investment-grade mandates, and the IG universe could suffer declines as a result. Should the high-yield market struggle to absorb any significant increase in volume resulting from such downgrades, it could cause additional volatility in high-yield corporate valuations as well.
Valuations in corporate bond markets are historically tight
Option-adjusted spreads (December 31, 1996–September 30, 2018)
Source: Bloomberg Barclays, as of September 30, 2018. High yield is represented by the Intercontinental Exchange (ICE) Bank of America Merrill Lynch (BofA ML) U.S. High Yield Master II Index, which tracks the performance of globally issued, U.S. dollar-denominated high-yield bonds. Investment grade is represented by the Intercontinental Exchange (ICE) Bank of America Merrill Lynch (BofA ML) U.S. Corporate Master Index, which tracks the performance of publicly issued, fixed-rate, nonconvertible, investment-grade, U.S. dollar-denominated corporate debt having at least one year to maturity and an outstanding par value of at least US$250 million. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Currency markets may continue to be whipsawed by short-term volatility
Currency markets have historically been a source for uncorrelated returns, but here, too, we see significant challenges ahead. In a perfect world, currencies fluctuate based on the relative strength of their home markets’ underlying economies, interest-rate differentials, and rates of inflation, among other things. But in recent months, headline risk has tended to crowd out fundamentals—a trend that may continue in 2019. With a divided U.S. federal government set to take the reins in Congress beginning in January, the threat of political gridlock—including government shutdowns—has grown significantly higher. Tension surrounding trade and tariffs, particularly between the United States and China, remains a constant source of uncertainty, as does the potential for a so-called hard Brexit—or no Brexit at all.
Our view continues to be that the U.S. dollar appears overvalued relative to other DM currencies, while many emerging-market currencies appear oversold. That said, any currency positioning in 2019 will need to balance the longer-term, cyclical opportunities with the risk of continued headline-driven volatility.
Navigating bond market headwinds requires a flexible approach
While fixed-income investors face a number of challenging conditions, we believe there are also opportunities for those willing to pursue a flexible, global approach. Certain parts of the Asian and Latin American bond markets, for example, offer relatively attractive yields and solid fundamentals. When it comes to emerging markets, we favor those economies running current account surpluses—meaning the government isn’t reliant on foreign capital to fund operations—and that are less dependent on commodity exports.
While risks exist in the corporate bond market, we believe those risks can largely be mitigated by taking an active approach. The more speculative tiers of the high-yield market are particularly vulnerable to any economic shocks; the more attractive opportunities are in the higher-quality segments of the high-yield market, in our view. Within IG corporate debt, we currently favor structures that provide optionality on rates, including floating rate, fixed-to-floating securities, and step-up coupons. We also see the potential for opportunities later in 2019 as short-term interest rates move higher to invest in short maturity, fixed-rate issues as well.
We’re also finding opportunities in somewhat more niche segments of the market. Floating-rate bank loans, for example, can offer a degree of insulation from the effect of rising rates; their coupon payments reset as short-term rates move higher. Bank loans also entail comparatively less credit risk than senior, subordinated, and convertible debt, and typically sit at the very top of a company’s capital structure. We also believe there are areas worth an allocation in the securitized markets; for example, in asset-backed securities—particularly securities backed by franchise royalty payments—and in certain single-property commercial mortgage-backed securities, which can provide diversification away from pure corporate credit risk and have valuations that tend not to be heavily influenced by changes in interest rates or geopolitical events.
The bottom line is that today—nearly a decade into a bull market for equities and three years into the Fed’s current campaign to normalize interest rates—we believe income investors will need to not only cast a much wider and flexible global net, but also strike an appropriate balance between quality, stability, and liquidity in order to generate attractive returns without taking on excessive downside risks.