Three themes dominated the discussion when our fixed income teams gathered for their latest quarterly outlook meeting. The first was the flatness of yield and credit curves in several markets and its implications for short-duration bonds.
The second was the related value opportunity in hard currency emerging markets debt. And the third was the forthcoming policy adjustments from the European Central Bank.
It was an energising conversation. There is the prospect of volatility in some core European bond markets that have been mill pond still for a long time and, most importantly, there is finally some yield for investors to play for in traditional, high-quality markets.
Yield curves have been flattening decisively since the start of 2014. In the US, that flattening has been led by a rise in short-dated yields, as the Federal Reserve has been tightening policy. By the end of June there were barely 30 basis points between the yields of the 10-year and two-year US Treasury bonds.
In US investment grade credit, there is now only around 60 basis points’ difference between full-index yields and those of one- to five-year indexes. Move down to high yield and that spread falls to less than 15 basis points. In emerging markets, the curve has even been slightly inverted: at the end of May, the one- to three-year bonds in the hard-currency JPMorgan EMBI Global Diversified Index were actually yielding 12 basis points more than the full index.
Right now, working at short duration, investors can build an investment grade portfolio, add a dash of high-quality high yield and emerging markets debt, and come out with around a 4.5 per cent yield profile. This opportunity to earn a competitive nominal and real return in short-duration fixed income is a significant change from the last few years, and one that is likely to attract investment capital over time.
That short-duration anomaly in hard currency emerging markets debt is only one part of a broader, very attractive value opportunity in the asset class. One of this year’s notable fixed income stories has been the underperformance of emerging markets debt, particularly against US high yield.
Despite higher average credit ratings, the spread of the JPMorgan EMBI Global Diversified Index over US Treasuries is as wide as that of the Barclays US High Yield Index for the first time since 2005.
Is that an early warning of a bigger bout of risk aversion to come in response to higher rates, a stronger dollar and a potentially escalating trade war? Or is it merely a wobble in the face of a temporary pullback in growth outside the US, setting up an attractive entry point?
There are clear risks out there, and spreads may widen before they tighten again, but we favour the latter view. Global growth remains solid and we ultimately believe that will help drive a rebound in EM fixed income.
The longer-term dynamic is the introduction of ECB policy changes toward tighter policy. For two or three years, the market’s singular focus has been Fed policy. Now, however, markets diverge from the central bank’s estimate of its terminal rate by little more than 25–50 basis points.
Everyone is essentially on the same page.
It’s the ECB that’s a wild card now. Its latest guidance is to expect a first rate hike no earlier than the second quarter of 2019, even as it aims to stop its quantitative easing purchases before the end of this year. At first glance that looks like a clear message, but we think it could be enough to raise big questions about how fast it will need to hike once the summer of 2019 comes around.
Outside of idiosyncratic situations such as the recent Italian elections, European bond markets have remained placid for a long time, supported by negative policy rates. German Bunds have been stuck in a particularly tight range. As the focus shifts from the Fed going through the motions to the ECB preparing its exit from extraordinary post-crisis policies, however, we anticipate a transfer of volatility — and opportunity — from US dollar to euro-denominated fixed income.
Put these three themes together — compelling short-dated yields, attractive value in emerging markets and the first stirrings of volatility in Europe — and at long last, the world of fixed income is starting to create meaningful opportunities for investors.
Ashok K. Bhatia is Senior Portfolio Manager — Multi-Sector Fixed Income at Neuberger Berman.