We believe there are eight reasons to be fearful for bond investing this year. Four of these relate to worries about the potential returns from the highest quality bonds in the developed world, while three are ways of adding value which, although they may have worked last year, are unlikely to do so in 2018. The final one is the fact a competitor asset class appears to be offering superior returns – again.
The first concern is inflation, which is creeping higher. For the last decade, deflation or disinflation was the dominant theme. Now, as the economic recovery has spread to so many core countries, energy and metal prices are lifting again, and the numerous pools of spare skilled labour across the world are reducing in number and size. Each small increase in inflation expectation causes a bigger increase in bond yields. Buying inflation-linked bonds, whose prices can also be affected by the level of nominal yields as well as inflation and supply/demand factors might not be the answer. What one gains on predicting rising inflation might be smaller than the losses from rising conventional yields.
Secondly, policy rates are starting to move up, pulling yields higher across much of the developed world, led by North America. After years of interest cuts, most central banks have reached a nadir. Bond markets will lose the tailwind that they have enjoyed, off and on, for over 30 years.
In addition, the extraordinary purchases that central banks adopted are slowing, have stopped or are being reversed. US Treasuries have sold off, partly due to one of the biggest buyers turning into a seller. The prospect of reduced buying by the ECB has driven European government bond yields higher; the ECB’s QE programme was huge in respect to net bond issuance, and vast relative to the size of the US QE plan in that regard.
Fourthly, the level of yields for high quality bonds is not at all high. Many trillions worth of bonds still offer negative yields to maturity. Even with positive yields, the quantum is rarely high compared to the last five decades. There is little or no margin of safety in these assets. Given that bonds have a terminal price, holding bonds with a negative yield to maturity is a guarantee to lose money in nominal terms, to lose more if there is inflation and lose yet more if there is a default.
One common answer to all four concerns is to short bonds (go short duration, in market speak) or buy funds that do short duration. Shorting bonds whose yield is negative might be a far cheaper exercise than ever before, and where yield curves are flat there is little extra cost that develops over time. GAM’s unconstrained/absolute return bond funds do just this and are short duration in 2018.
Three traditional techniques for adding value are less appealing. Buying longer-dated debt garners the least extra income compared with much of history – be it US Treasuries or, say, in corporate and financial issuer subsectors. In parts of Europe the curves are somewhat steep but absolute levels of yields are unusually low – be it in Germany, where the economy is thriving but local yields are negative, or say Hungary, where intermediate yields have fallen below 1%. These yields should rise in 2018.
Credit markets are the tightest they have been since the global financial crisis. Merger and acquisition activity indicates that yields should be higher. Spreads on European bond indices are below 40 basis points (bps) for investment grade and below 220 bps for crossover (the cusp between investment grade and high yield); these barely cover the cost of expected losses from defaults. As treasurers realise that the all-in yields (government plus credit spread) are unlikely to go lower, bond issuance balloons. When quantitative tapering begins and bond fund buying fades, demand might struggle with yet more supply. A bond buying strike might ensue; in the last three months, spread contraction has ceased. Within GAM’s unconstrained/absolute return bond funds we have bought protection against generic spreads moving wider, but – in case that proves incorrect – we are insulated from further tightening this quarter.
If buying long-dated debt or traditional credit does not appeal, then trading market swings might remain as an option for active investors. In 2017, realised volatility in many parts of the investment universe was hard to find – some prices rose steadily all year, with barely a hiccup. Passive long investing looked smart. If prices now gyrate more, and especially if they drop, active styles will again look smarter. Meanwhile, the value of options whose prices are influenced by expectations of volatility and interest rates might rise as both factors pick up this year. Buying options, not selling them, is a more prudent strategy when markets have been anaesthetised and become expensive (where put options might shine).
Finally, there is the number one competitor to bonds, namely equities. 2017 saw equities beat bonds again, in the US by nearly 20% in total return terms, and for the sixth year in a row. German bonds were the laggard, starting with among the most unattractive yields and finishing there too; yet the DAX made over 12% in local terms. In principal emerging markets, buoyed by generally stronger currencies, many bond sectors did well but equities mostly did better. The waterfront growth outlook for the next few quarters is remarkable, and is sufficiently robust to help lift corporate earnings in most industries despite rising wages and raw material costs. Dividend yields still look great compared with bond yields from the same quality company. (That said, credit metrics continue to be at least adequate – with much debt light on covenants, low in coupon and long-dated in nature. Defaults should be few in 2018.) Were it not for the lofty equity valuations and the time since the last significant decline so long, there would be a greater equity mania. Fortunately, the GAM unconstrained/absolute return bond funds have held 10% in convertible bonds, which are once again making a material net positive contribution. Convertibles have hitherto outshone high yield bonds in periods of rising interest rates.
Policy rates are moving up across North America and the UK. After years of interest cuts, most central banks have reached a nadir. In the case of Europe and Japan, any change in policy could be very slow to arrive. That will disappoint some short sellers. But removing the most aggressive of emergency measures, to return short-term rates to zero or positive territory, would not be contractionary as much as eliminating distortions. 2018 could see particular weakness in five-year bond prices in these countries. More widely, bond markets are losing the tailwind of declining policy rates that they have enjoyed, in one country then another, for nearly 30 years.