Bond markets are awash with rumor and uncertainty as they wait to see what central banks will do next. With the European Central Bank (ECB) having bought around €350bn of European corporate loans over the last year[1] and the Bank of England £10bn over the last six months, on top of vast government-bond purchases, markets are hanging on policymakers’ every word. With very little room for error in bond markets, any policy misstep or change in policy wind could leave bond investors nursing their wounds. As U.S. Federal Reserve Chair Janet Yellen, ECB President Mario Draghi and other central bankers attend the Economic Policy Symposium at Jackson Hole this week, many will be looking for indications as to how the grand experiment in quantitative easing might come to an end.
But while central-bank support may have been helping to keep bond markets from selling off, as there is a forced buyer, the real question for investors is whether they are being rewarded for the risk of the corporate outlook deteriorating or the policy direction changing.
The beauty of multi-asset investing is often considered to be diversification, as owning different asset classes with uncorrelated returns should help to reduce the overall volatility of returns over time. However, the real advantage in our view is being able to determine the potential risk and returns available in different asset classes and geographies. We contend that multi-asset investing is as much about what you don’t own as what you do, and at times there is just nothing to get excited about in some areas.
In the years since the 2008 financial crisis, authorities have engaged in ever-greater policy intervention to shore up economic growth. However, as our ‘state intervention’ theme identifies, policies such as quantitative easing and ultra-low interest rates have had unintended consequences such as inflated asset prices and misallocation of capital.
We have previously discussed the significant issuance of corporate debt to undertake share buybacks and the risks that this poses to balance-sheet strength, and our ‘debt burden’ theme encapsulates the sheer scale of the global debt problem, with total debt outstanding still greater today than it was before the financial crisis.[2] Given the low cost of financing debt, it is not surprising that debt has continued to increase.
As central banks have purchased huge swathes of bond markets, with the ECB alone buying €1.5 trillion in government bonds[3] in addition to the aforementioned €350bn in corporate loans, it is logical that bond yields have trended lower too. As shown below, the yield on outstanding investment-grade debt is at all-time lows, with investment-grade bonds in the UK yielding just 2% and those in the U.S. 3.1%.
Yields to maturity (returns in bond markets for a buy-and-hold investor) are at all-time lows:
The story is worse in Europe, with 70% of the European investment-grade bond market yielding less than 1%, and 93% yielding less than 2%.[4] This is less than the inflation rate that central banks are currently targeting, and there is much talk of moving this target higher.
In addition, investment-grade spreads (the difference between the yield on an investment-grade bond versus a similar-maturity government bond) are at the lowest they’ve been in a decade, as highlighted below.
At the same time, duration (a bond’s sensitivity to interest-rate movements) has increased, meaning investors are now more sensitive to changes in the yield (in either direction).
Today investors in investment-grade bonds receive a lower return and have to take higher interest-rate risk than at any time in the last two decades. In fact it would take less than a 0.3% rise in the yield to wipe out any total return received over a year in the European or U.S. investment-grade bond markets, leaving very little room for error.
This is why our Multi-Asset Diversified Return strategy currently has the lowest weight to bond duration in its 14-year history.[5] While many are talking about “cash being trash”, in my view investment-grade bonds overall as an asset class offer little more to investors, and given the yields available in bond markets the opportunity cost of holding cash has never been lower.
Of course, it is still possible to find opportunities in select corporate bonds in areas where there is thematic support. Furthermore, shorter-dated bonds offer less duration risk and can provide a pickup versus cash. However, taking investment-grade bonds as a whole, in my view it is highly likely that another asset class, in some part of the world, at some point over the next five years, will offer better prospects than can be achieved in the investment-grade bond market today.
While some investors may want to play until the music stops, as Balthasar in Shakespeare’s play once said, the corporate bond markets appear to be highlighting “There’s not a note of mine that’s worth the noting”.
[1] The figure includes securities purchased via the CSPP (corporate sector purchase program), ABSPP (asset-backed securities purchase program) and CBPP3 (covered bond purchase program). https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html
[2] Institute of International Finance, Global Debt Monitor – June 2017. https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017
[3] Via the public sector purchase program (PSPP). https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html
[4] Source: Bloomberg, August 2017.
[5] Positioning as at August 23, 2017.
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