James Cielinski, Global Head of Fixed Income at Janus Henderson, explores what a rising yield environment might mean for investors.
Epitaphs are being written daily about the death of the 35-year old bond bull market. Could the long feared bear market be upon us given the rapid ascent of yields? Led by the US and Europe, 10-year yields are higher by 67 and 36 basis points (bp), respectively, over the last five months*.
There are few more emotional terms than “bear market”; but it is important to define what this term really means. Investors should be less concerned about terminology and more about what a rising yield environment might look like, how it might impact returns and what investment strategies stand the best chance of succeeding in this environment. In fact, the range of potential interest rate outcomes is more manageable than many fear.
*Bloomberg, as at 12 February 2018.
Interest rates bottomed in mid 2016
We have already been in a bear market (of sorts) for the last eighteen months. Developed market government bond yields troughed in the summer of 2016. You would be forgiven for not appreciating the significance of this. Total returns from government bonds were positive in both 2016 and 2017 (see figure 1); hardly the definition of a classic bear market! Results were even better if one owned corporate or emerging market bonds. And for those that navigated the volatile, uneven rise in rates, it was even possible to produce some very robust investment returns.
Figure 1: yields on the upswing - G7 global government bond index
Source: Bloomberg, yield to worst and total return for ICE BofA Merrill Lynch G7 government index, in local currency terms, as at 12 February 2018.
Past performance is not a guide to future performance.
The secular arguments for low interest rates have been well documented. Globalisation, ageing demographics, faltering productivity and the mammoth debt overhang have relentlessly pushed the equilibrium level of rates lower. These forces have been persistent for decades and are not about to vanish. Sustainable, rapid growth will require stronger credit creation. Yet, the build up in debt, both pre and post-crisis makes this route unlikely.
The inflection point in yields was a reminder of the difference between yields staying low, as opposed to the argument that yields should not rise. Secular forces (generating low inflation) will continue to supress yields. Cyclical forces, coupled with extremely low starting valuations, are pushing yields higher today. However, we have likely reached the point where this tug of war moves to a new phase — tighter monetary policy is coming, although much is priced in, and inflation expectations have also moved higher.
Bear market or not, yields are unlikely to shoot sharply higher from today’s levels. Cyclical forces are likely to push rates higher, but powerful structural factors will act as an upper bound and preclude a return to pre crisis levels. Equilibrium 10 year yields are not far north of 3% but a more convincing pick-up in wage inflation or credit creation is needed to move to a 3.5% level. And a move to 3.5 – 4.0% at this late stage in the cycle would require strong global economic acceleration and a regime shift in fiscal policies. You can call it whatever you want, but these outcomes do not spell impending doom. A bond bear market is not the equal of an equity bear market.
Figure 2: US 10 year Treasury yield heading higher but not alarming
Source: Bloomberg, generic US 10 year government bond yield, 31 January 1980 to 31 January 2018.
A central bank double whammy
Global bonds are contending with the headwind of rising policy rates and the decline of central bank asset purchases. The removal of accommodation has left many wondering who the next marginal buyer of bonds might be. But there are limits to policy. The European Central Bank for example, cannot tighten too much before the soaring euro crimps export growth. A policy mistake may also jeopardise equity market stability, the most important component of financial conditions. Moreover, central banks will be data dependent. Figure 3 shows that the most important data — core inflation — is mostly missing in action.
Figure 3: boredom alert — global core inflation has barely moved
Source: Bloomberg, 31 December 2007 to 30 September 2017.
Diversity — the beauty of global fixed income markets
A rising rate environment does not affect all bonds equally and may not imply negative total returns for many bonds. Credit and emerging market debt may perform better or worse than government bonds. Other assets such as floating rate notes and inflation-linked bonds can help protect from rising inflation. And finally, higher rates are improving the ability of bonds to provide diversification in a broader portfolio via better performance in ‘risk-off’ events.
Figure 4: scenario analysis – 12-month estimated returns in a rising yield environment
Source: Janus Henderson Investors calculations as at 12 February 2018, expected returns using stress tests from RiskMetrics. Expected returns are estimates only and are not guaranteed; based on expected correlations and volatilities, which may be subject to change. Note: credit spread tightening has been excluded in the analysis for investment grade expected returns. Euro government, Euro IG corporate and Euro high yield returns are in euros, all others are in US dollars. Bp = basis points. IG = investment grade.
The current cycle is getting old. There is a need for many investors to de risk and fixed income should play a vital role. The challenge is to recognise that many of the investment rules have changed. Growth at full employment is not generating inflation. Higher corporate leverage is not generating defaults and wider credit spreads. Central bank behaviour continues to distort markets. Benchmark-agnostic approaches that seek to solve today’s problems might stress income, attractive returns with downside protection or low exposure to rising interest rates.
It may not matter whether this is a mere correction or a bear market. Returns will of course differ, but the right approach for investors should be similar for both. If we are witnessing a more sustainable inflation upturn, it implies policy normalisation and a new rate environment, which requires a flexible approach. Alternatively, we may be nearing the top of the range for rates, with inflation once again failing to accelerate. But again, this outcome demands a flexible approach.
Bond markets are not cheap and credit spreads are tight. The challenge is to look beyond the mainstream for opportunities, adapt to changing rules and rotate across a wide range of investment opportunities. In my view, flexibility is a prerequisite to success in today’s markets.
The views presented are as at 14 February 2018. They are for information purposes only and should not be construed as investment advice. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent and may be subject to change.