Can investors still rely on bonds to provide safe, low-risk returns in the mid-single-digit range?

Analysis - 7/20/2017

Fixed-income markets seem exhausted by almost 10 years of ultra-loose monetary policies across the developed economies.

One striking example is the level of the two-year German Bund yield at -0.60%. This shows the addiction of bonds to central banks’ actions. At the same time Portugal’s and Greece’s 10-year yields respectively stand at 2.8% and 5.8%, illustrating that not all fixed-income markets are on a roll.

To achieve a return in the mid-single-digit range, we think that investors should opt for flexible, active, selective management of their bond buckets. Sources of profit and risk are still there for the taking. Today more than yesterday we need to rely on specialists when it comes to allocation, security selection and dynamic management of the interest-rate and credit risks. As the sharp moves in German yields seen in late June demonstrated, yet again, flexibility is the key to investing in fixed-income markets in troubled regions. 

Here are the main areas of opportunity we see at present:

  • Financial debt is the segment where we perceive the most value in both absolute and relative terms. Valuations are low and yields on subordinated debt remain highly attractive compared with ordinary corporate bonds with similar ratings. With worries about political challenges to the European Union on the wane, with its banking system looking increasingly healthy and with scope for regulatory easing, financial bonds have ample underlying support.
  • Despite the fading perception of risk in Europe and hints of asset-purchase tapering by the ECB, we see value in specific investment cases. Portuguese and Greek sovereign bonds, in particular, offer attractive yields and further downside potential in spreads. We believe that Portugal in future will be included in fixed-Income benchmarks and that talks on debt relief for Greece will start soon after the German election.
  • In the corporate segment, US investment-grade issues have an attractive risk/return ratio and good absolute yields compared with peer paper in other developed countries. They also provide duration-neutral exposure to the benefits of Trumponomics for American companies. High yield in the eurozone continues to offer a certain amount of value, with spreads that are below historical averages but with lower market leverage. Indicators such as bp per turn show further price performance potential.
  • In emerging markets, with improving fundamentals and steady inflows of cash on the one hand, and with exchange-rate volatility and political uncertainties on the other, we favour hard- currency, specific investment cases while remaining cautious on market beta.

Risk areas:

  • German Bunds and other highly rated government bonds are a source of concern as central banks apparently shift towards a more hawkish stance. This could already be sensed in recent statements by Mario Draghi of the ECB, Mark Carney of the Bank of England and Stephen Poloz of the Bank of Canada.
  • Meanwhile we think the US Federal Reserve will deliver more hikes than are currently priced in by the market, so the front end may suffer.
  • Tight spreads in emerging market debt and corporate high yield (especially in the US) also imply lesser cushioning potential in case of a risk-off move. We therefore have some tactical protection in these segments.Tight spreads in emerging market debt and corporate high yield (especially in the US) also imply lesser cushioning potential in case of a risk-off move. We therefore have some tactical protection in these segments.

Benjamin Melman
Directeur Allocation d’actifs et Dettes souveraines
Edmond de Rothschild Asset Management

This analysis is an extract from the first House View published by Edmond de Rothschild. 

This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes. 

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