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Don’t feel obliged to invest in bonds

Investment strategy - 1/23/2018

In short
  • Long-term rates are feeling mild upside pressure
  • Risks and opportunities are both very limited
  • Our preference goes to subordinated financial bonds

In their 2018 projections, few investors are ticking bonds as a potentially important contributor to the overall performance of a diversified portfolio.

To begin with, economic conditions and the actions of the major central banks are conducive to upward- trending yields. The US Federal Reserve is set to go on normalising its monetary policy  and  observers will be scrutinising every ECB statement for wording designed to prepare the markets for its first rate hike. Moreover the combined assets of the leading central banks will cease to grow this year (due to the shrinking of the Fed’s balance sheet and the slower expansion of the ECB’s and the BoJ’s), eliminating a major source of support for debt instruments.

Term premiums (the component of interest rates which reflects neither monetary policy expectations nor a credit premium) are depressed, illustrating how expensive and vulnerable bond markets have become. Even so we do not believe inflation will move back up significantly, meaning that the uptrend in long- term rates should remain limited (though we cannot rule out episodes of volatility). We therefore advise a defensive approach to the duration risk while not being overly wary of European issues, since money- market rates are still negative. The important thing will be to manage sensitivity very tactically. Even though central banks hope that movements in long-term rates will remain very gradual, history has shown that bond markets are prone to tensions that can flare up and die down suddenly.

"European and US inflation-linked bonds have a compelling asymmetric risk profile."
Benjamin Melman
Head of Asset allocation and Sovereign debt
Edmond de Rothschild Asset Management

 


Opportunities in inflation-linked bonds and some peripheral countries

European and US inflation-linked bonds (with a hedged duration risk) have a compelling asymmetric risk profile. Up to now, because inflation has remained abnormally low, investors have not been tempted to seek protection so the valuations of these issues are still relatively attractive. But since it would be legitimate to expect a certain amount of inflationary pressure in an accelerating global economy, all it would take is a minor upsurge in prices to arouse far greater interest in these instruments.

The yields on peripheral country bonds have come down considerably, so that credit spreads now seem to reflect the risks attaching to this  asset class adequately.  Conditions that were critical in some cases have simmered down. Portugal is back to investment grade1 and Greece finally has its head above water again. But while the outcome of last year’s French and Dutch elections reassured investors, political risks are not a dead issue in Europe. Most countries in the eastern European Union now have a populist government with anti-EU policies. In Austria the far-right party, also opposed to Brussels, has key cabinet posts in the governing coalition. And more uncertainty lies  ahead  with the elections scheduled for Italy this year. In Catalonia the political risk is bound to linger. As a consequence, while continuing to expect higher yields on these countries’ sovereign bonds than on those of the core members, we are taking a more tactical, selective approach. On a proportional basis we are heading into the new year with a preference for Greece and Portugal.

Low returns and low risks in credit

Spreads have narrowed so much that opportunities in the main classes of fixed income are few and far between. In the credit segment, premiums have sunk to historical lows and this is fully justified. Debt ratios are under control and the economic outlook is brightening. Companies have moreover extended the maturity of their debt, thereby smoothing its servicing over time, so there is no concern about refinancing requirements ahead. The ECB will probably continue buying corporate bonds during the first nine months of 2018 at least, which will help to hold down supply. In other words, as we see it the credit risk is low but so are yields.

"The segments which we were expecting to catch up have already largely done so."

 

We see more opportunities in subordinated2 financial issues. Fundamentals in this segment are improving, thanks to a decreasing incidence of non-performing loans and a rosier regulatory outlook. Moreover, with long-term interest rates on the rise, financial bonds should perform better than other segments of fixed income, since the profitability of banks turns up in these conditions (along with their credit risk). High- yield3 bonds will likely be able to deliver returns near their yields and benefit from the drop in the default rate that we are expecting. In the lower-yielding corporate investment-grade segment, the US market (hedged for the forex risk) pays higher coupons and provides scope for steadier returns than in Europe. Emerging bonds denominated in hard currencies should also be able to deliver performances close to their yields. However, they could be more volatile as these companies are more exposed to risks arising from US monetary tightening or an unexpectedly steep downturn in the Chinese economy. Moreover, emerging debt has been widely over-represented in investment portfolios, so huge amounts of money have poured into this segment in recent years. These flows could reverse, especially if US and European coupons were to become more attractive again. As for bonds in local currency, the main risk we perceive here is a resurgence of volatility in the emerging currencies. These have amply benefited from the ultra-accommodative monetary policies of central banks in the developed countries and it is time for the tide to turn.

In short, bond markets now offer fewer opportunities because the segments which we were expecting to catch up (subordinated financial bonds and issues in some of the peripheral countries) have already largely done so. But while anticipating heavier volatility, we also believe that some types of bonds still hold out the prospect of positive returns exceeding those on money-market instruments. We may be starting off the new year underweight fixed income in our allocations but that does not mean we are neglecting this asset class.

 

Benjamin Melman
Head of Asset allocation and Sovereign debt
Edmond de Rothschild Asset Management

 


 

1 Bonds rated as high quality by rating agencies.

2 Debt is considered to be subordinated when its redemption depends on the earlier payment of other creditors.

3 Corporate bonds with a higher default risk than investment grade bonds but which pay out higher coupons.


Drafting finalised on 10 January 2018 AVERTISSEMENT This brochure was prepared by Edmond de Rothschild Asset Management (France). The following entities, including their branch offices and subsidiaries, limit themselves to making this brochure available to clients: Edmond de Rothschild (Suisse) S.A., located at 18 rue de Hesse 1204 Geneva, Switzerland, subject to the supervision of the FINMA, Edmond de Rothschild (Europe) S.A., located at 20 boulevard Emmanuel Servais, 2535 Luxembourg, Grand Duchy of Luxembourg, and subject to the supervision of the Luxembourg Commission de Surveillance du Secteur Financier (CSSF), and Edmond de Rothschild (France), Société Anonyme governed by an executive board and a supervisory board with a share capital of 83 075 820 euros – RCS Paris 572 037 026, located at 47 rue du Faubourg Saint-Honoré 75008 Paris. This document is non-binding and its content is exclusively for information purpose. Any reproduction, disclosure or dissemination of this material in whole or in part without prior consent from the Edmond de Rothschild Group is strictly prohibited. The information provided in this document should not be considered as an offer, an inducement, or solicitation to deal, by anyone in any jurisdiction where it would be unlawful or where the person providing it is not qualified to do so. It is not intended to constitute, and should not be construed as investment, legal, or tax advice, nor as a recommendation to buy, sell or continue to hold any investment. Edmond de Rothschild Asset Management or any other entity of the Edmond de Rothschild Group shall incur no liability for any investment decisions based on this document. This document has not been reviewed or approved by any regulator in any jurisdiction. The figures, comments, forward looking statements and elements provided in this document reflect the opinion of Edmond de Rothschild Asset Management on market trends based on economic data and information available as of today. They may no longer be relevant when investors read this communication. In addition, Edmond de Rothschild Asset Management shall assume no liability for the quality or accuracy of information / economic data provided by third parties. Any investment involves specific risks. We recommend investors to ensure the suitability and/or appropriateness of any investment to its individual situation, using appropriate independent advice, where necessary. Past performance and past volatility are not reliable indicators for future performance and future volatility. Performance may vary over time and be independently affected by, inter alia, changes in exchange rates. Edmond de Rothschild Asset Management refers to the Asset Management division of the Edmond de Rothschild Group. In addition, it is the commercial name of the asset management entities of the Edmond de Rothschild Group. EDMOND DE ROTHSCHILD ASSET MANAGEMENT (France) 47, rue du Faubourg Saint-Honoré - 75401 Paris Cedex 08 - France Société anonyme governed by an executive board and a supervisory board with capital of 11.033.769 euros AMF Registration number GP 04000015 – 332.652.536 R.C.S. Paris