Global Head of Fixed Income Jim Cielinski discusses some of the factors shaping bond markets, from higher yields signaling stronger credit fundamentals to the increased investor interest in sustainability.
- We think inflation risks will prove transitory and believe the bulk of the interest rate move – and the pace of yield increases – is largely behind us.
- When the rise in yields is tied to the potential for economic growth, it can be positive for many parts of the credit market.
- A more permanent legacy of the pandemic is the increased interest in sustainable investing and the contribution fixed income investors can make in achieving more sustainable outcomes.
Will the rise in yields be sustained?
Jim Cielinski: One of the questions that we get most often is whether or not this rise in yields is going to be sustained. And I think my answer would be no, certainly as it pertains to the pace of yield increases that we've seen. It's important to know that yields are really a reflection of inflation and inflation expectations, but also of short-term policy rate expectations. Now, inflation risk has been repriced across most markets, and with central banks remaining steadfast in their commitment to keep policy rates low, I think we have seen the bulk of the interest rate move.
Growth is going to be accelerating both because of the vaccine rollout, but also because of the enormous fiscal stimulus that we've seen globally, so there is a risk that yields can move a little bit higher from here. But I think the bulk of the rise that we have seen – 100 basis point increase, for example, in the U.S. – is largely over and done.
Might we depart from the low inflation path?
Inflation is a topic that is at the front of all of our minds and people are concerned that the low inflation environment that existed pre-pandemic is now going to be a thing of the past. I think the jury is still very much out on that. Certainly the low inflation that we saw last year is gone for at least the next few months, but I think persistent inflation, sustained high inflation, really requires us to first of all close the output gap, it requires some private credit creation. I think it probably requires a drawdown in the huge excess savings that we've built up globally. So those are still big ifs. If those do happen, then I think you can see inflation probably move a little bit higher as we go forward. But you know, we still have these secular trends – whether it's demographics, whether it's the debt overhang – that should keep, I think, interest rates and inflation relatively low, although not as low as they were last year.
Can a rise in yields be beneficial?
Some people ask whether or not there are some benefits to the rise in yields, and of course there are. When the rise in yields is really a reflection of stronger growth and stronger potential growth, a little bit of inflation even can be positive for many parts of the credit market. So it's painful as yields go up for the highest-quality parts of the market; you’ll see capital losses. But once things settle down, you're looking at a picture with both higher income but, again, if the economy is growing, often the fundamentals are improving as well. So I would point people to look forward, not backward.
What does stronger growth mean for credit markets?
And if we do look forward, I think it has important implications for asset classes like corporate credit or asset backed securities. Stronger growth is unambiguously positive for the fundamentals of credit. So long as it's not so strong that it forces central banks to start tightening policy, I think what you'll see is a better environment for earnings. Cash flow is already rebounding strongly and the valuations of real assets that also kind of often underlie asset backeds (ABS) and mortgages are rising quite appreciably. So I think deleveraging as we see growth going forward will be a key theme. I think default rates, which are already low, will move to almost frictional levels in most developed markets. And as you see this unfold, I think the fundamental backdrop through the stronger growth will remain a tailwind for corporate credit and asset backeds.
Has the pandemic shifted attitudes towards sustainability?
One of the themes that has really unfolded during the pandemic has been the huge amount of interest in sustainable investing and the huge interest in ESG investing. And by that, I mean the environmental, social and governance factors that we incorporate into what we do. This is a megatrend that shows no signs of stopping. Investors want more than just good risk-adjusted returns from their investments. They want to know the companies they're invested in are perhaps doing the right thing for the environment. They want to know that sustainability often can imply that, in a world of disruption, these are the companies that are going to respond to the changes in the next 10 years and be around and thrive. Or it might mean a positive social impact on top of generating good returns. I think the ability to now combine these various facets into your investing model is something that has really emerged stronger and will continue to only grow stronger in the years ahead.
Note: Bloomberg, U.S. generic 10-year government bond yield, yield rose 106 basis points in six months to 31 March 2021.
Credit fundamentals: Factors that contributes to the valuation of a security, such as a company’s earnings or the evaluation of its management team.
Environmental, social and governance (ESG) are three key criteria used to evaluate a company’s ethical impact and sustainable practices.
Fiscal policy/stimulus: Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt.
Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.
Output gap: The output gap is an economic measure of the difference between the actual output of an economy and its potential output. Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity.
Yield: The level of income on a security, typically expressed as a percentage rate.