While central banks' policies will continue to play a major role in fixed income, not least through their effect on exchange rates, yields on global bonds markets have been at historically low levels and according to some investors the global macroeconomic context will not be supportive going forward.
However, others believe yields in the corporate space have improved compared to twelve months ago and valuations now look more attractive.
In this context, Third Avenue's halting redemptions from its $788 million Focused Credit fund on December 11 has sparked discussions over the possibility of a liquidity crunch and a meltdown in the bond markets.
Citywire collated the views of fixed income investors for the year ahead. These comments were made before the Federal Reserve rate hike, which took place on December 16.
Phil Apel, head of fixed income, Henderson Global Investors
In the main we are more positive compared to this time last year, particularly away from sovereign markets. This is because the repricing of credit markets in 2015 means that yields are generally higher and spreads wider than at the start of 2015, so valuations for the medium term are at a more attractive starting point.
There is likely to be more volatility in 2016 and defaults are set to rise but this will create opportunities and as an active manager you have to look at that with enthusiasm.
We expect growth to be around trend in the US and Europe but still challenged in emerging markets. Against that background we expect inflation to pick up towards central bank objective levels, in part because the year-on-year comparisons will see some of the sharp commodity price drops fall away. In our view, the Fed will be on a path of tightening that is somewhat faster than the market currently expects but will still be gradual compared to the historical average.
The repricing of dollar liquidity will present periodic challenges for all financial assets, including fixed income. US policy will contrast with Japan and Europe. We expect to be relatively defensively positioned towards duration exposure and there may be some upward pressure on spreads in investment grade.
Defaults in high yield are likely to pick up, albeit driven by the commodities sector and this will renew the focus on idiosyncratic risk. That said, we continue to prefer credit to cash and sovereign bonds, although the ongoing withdrawal of liquidity and periodic repricing means investors need to be discerning.
European credit markets face a less challenging backdrop than the US. An accommodative central bank, more favourable technical conditions in terms of supply, together with the yield-seeking activities of investors facing negative interest rates in some European countries, should offer a more supportive fixed income environment.
Bill Eigen, Citywire A-rated, JPM Asset Management
In today’s market it is more important than ever for bond fund managers to have the flexibility to seek out value as well as meet redemptions without the need to sell into a falling market.
A hallmark of our strategy since inception has been to act as a provider of liquidity in periods of market stress, hence we’ve maintained an approximately 30% cash balance in recent months. For example, during the European sovereign debt crisis, we took our cash levels down to 20%, in order to take action as all forms of market risk went on bargain sale. We stayed the course to realise strong subsequent returns in 2012 and 2013 as a result.
Today we are doing the same thing – responding to market volatility by adding to positions that we like at discounted levels. History suggests that adding to risk during uncomfortable time periods has led to strong risk adjusted results in the long run. That’s why we are still very positive on the return prospects for high yield debt over the longer term, despite the current turmoil. In fact, we think the high yield selloff is overdone for the most part, primarily due to weak liquidity.
While outflows may continue on the HY market in the short term, longer term the world is still faced with a tremendous income shortage, which will eventually push investors back into higher yielding parts of the market. This is not 2008 and the global financial system is not on the verge of collapse. The froth that existed in the system back then is simply not here to continue fuelling selling pressure.
Jim Leaviss, head of retail fixed income, M&G
It’s not felt like it somehow, but 2015 has been a bear market for US and UK government bonds, with yields up around 20 to 30 basis points at most maturities. In stark contrast, European bonds have made new record lows this year – initially as the ECB announced quantitative easing QE and cut interest rates to negative levels, but again ahead of its upcoming meeting in December where further easing measures are widely expected.
German bund yields now have negative yields out to six years, and even Spanish and Italian debt, pricing in high default probabilities as recently as 2012, trades with negative yields at the short end of the curve.
Elsewhere in fixed income, we’ve seen stability in most investment grade corporate bond spreads in the UK and Europe, although some event risk has come back in the market, for example, spreads in VW bonds were hit badly after the emissions scandal.
US investment grade bond spreads have under-performed this year as companies issued huge volumes of debt, perhaps in anticipation of yields continuing to rise as the Fed starts to hike rates.
The US market has also seen some fundamental deterioration in credit quality: leverage has risen, partly as a result of share buybacks and M&A funded by borrowing. US high yield bonds were the under-performer of 2015, continuing the damage started at the end of 2014 as energy-related bonds (rigs, pipelines, exploration and refining) started to discount a prolonged fall in oil prices. And as other commodity prices (copper, iron ore) hit their lowest levels for years, bonds exposed to metals and mining also sold off. Outside of energy and commodity names, however, default expectations remain very low.
If there was a bear market for US and UK government bonds, it was nothing compared to that in emerging markets EM. Local currency EM debt had an awful year. The Chinese slowdown created fears for global growth, with commodity-exporting developing economies suffering as a result. As these fears rose, outflows from developing world ‘yield tourists’ exacerbated the EM debt price falls.
In the local currency space, many EM government bonds now yield more than 7% (Brazil yields over 15%) When coupled with falls in currency of 20-30% against the US dollar, we go into 2016 with a significant improvement in EM debt valuations.
Joe Benevento and Joern Wasmund, global co-heads of fixed income/cash, DeAWM
Fed chair Janet Yellen increasingly appears to be someone who is driven by the markets, rather than driving them. The rate rise trajectory in 2016 is still expected to be “low-and-slow” and the Fed is likely to try and signal this to the markets.
Normally, a “low-and-slow” approach would not be expected to boost the US dollar substantially ECB President Draghi may be deliberately loosening his grip, repeatedly signalling further monetary-policy easing (probably including a cut in the deposit rate).
The result could be a further significant appreciation of the US dollar as the rope moves. For a European-based investor, investing into more stable US assets may therefore become increasingly attractive, as they could offer the potential for augmenting already decent returns with currency gains.
Of course, yields may rise as the Fed hikes rates. But we believe that the rise in Treasury yields will be contained and that currency and carry will continue to provide an attractive cushion.
A strong U.S. dollar can affect fixed-income markets in other ways. For example, the headwinds it creates for commodity prices could hurt many emerging-market issuers too. The recent improvement in sentiment on emerging-market debt is just that – sentiment. It is not supported by a real turnaround in emerging market economic or corporate fundamentals. So we would stay neutral on emerging markets for now.
Luuk Jagtenberg, portfolio manager, Kempen
Government bonds are very unattractively valued. Such low valuations are only justified in the case of long-term deflation, which is one of our stress scenarios. However, we expect yields on government bonds to rise and revert to normal levels over the next ten years. This will be accompanied by negative price returns, especially if yields rise abruptly.
The current low expected returns provide insufficient compensation for this risk. In the case of credits, there is still sufficient reward for the credit risk taken. Credits are therefore valued neutrally. High-yield emerging market debt currency also offers sufficient reward.
However, this high-yield debt has generally been issued by countries now facing a slowdown in the business cycle, leading to substantial risk in the medium term. Moreover, many emerging markets currencies are difficult to hedge. These two factors combine to make high-yield emerging market debt unattractive at the moment.