Are fixed income markets overvalued?

14/11/2017

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​A comment we regularly hear from our clients, whether in individual meetings or at investor events, is that “bonds are expensive”. This, of course, is a fair point but is at odds with our current thinking. The reality is that in today’s world there are no ‘cheap assets’; and those that are, are cheap for good reasons.



In our view it is no longer possible to argue that bonds are cheap. Instead, we believe they are probably at or around fair value and reflect the current market environment in which we have low volatility, low defaults, low inflation and a reasonable level of global growth. 

Owners of bonds get their returns from two places: income and price movements. In light of current valuations, where spreads have tightened significantly post the Global Financial Crisis, we think that future bond returns will mostly come from the ‘income’ element. This is an environment in which a carry strategy (ie, collecting the bond's coupons) still works, because there are many bonds with reasonable levels of coupon to ensure a good income stream.

The chart below shows the typical returns from various fixed income assets and equities over selected periods.  


Chart 1: historical total returns for fixed income and equities 


Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

Source: Bank of America Merrill Lynch, Credit Suisse, Janus Henderson Investors, as at 31 October 2017.

Note: IG: investment grade; HY: high yield. Loans: Credit Suisse Western European Leveraged Loan Index and US Leveraged Loan Index. Total return year to date; annualised returns for 2, 3, 5 and 10Y. Corporate bond and loan returns hedged back to sterling; S&P 500 index returns in sterling.


Enough bonds in investors’ portfolios?
Another question we receive is whether we believe bonds are ‘under-owned’? It is clear that equities have attracted significant inflows and investors are feeling quite euphoric; typical late cycle characteristics. Equally, as chart 1 shows, fixed income asset classes have performed well on a 10-year view.

We would not argue that either asset class is cheap, but we do believe that investors should seek diversification by holding an appropriate level of bonds. Bonds, and particularly higher quality ones, tend to do well if equities sell off and so provide investors with that diversification. To illustrate this, while the S&P 500 index was down 38% in 2008 at the height of the crisis, the US investment grade (high quality) corporate bond index returned -7.9% and US 10-year Treasury 17%.

We think a lot of investors are currently focusing on where things can go wrong for bonds. The asset class has enjoyed a particularly strong run, with yields on US Treasuries reaching a July 2016 low of 1.36% (lower yields mean higher prices), although they have since climbed by over 1% from this low point*.


Rate rises – what will the impact be?
Investors also question whether the fact that the US economy is doing well, and Federal Reserve officials are suggesting more rate hikes are likely in the near future, mean that bonds are no longer a worthwhile investment? We suggest that they still are, and mainly because rate rises are likely to be measured.

The economy, while growing, is expanding far less quickly than historical norms, and inflation is also well anchored. We have long thought that Japan provided interesting parallels for other developed markets, given its ageing population and recovery from a debt fuelled crisis.

Based on the experience of Japan, we think that while we will see interest rates increasing, the rises are likely be measured and provide only a small headwind, which coupons should be able to more than offset. Also, within our portfolios, if bond yields rise, we will be able to reinvest our maturing bonds into more attractive ones with higher yields, which in time should boost fund returns.


Outlook and valuations
Chart 2 below is a comparison of the yields on various fixed income asset classes. Based on this, we are still constructive on investment grade and do see reasonable value, particularly within BBB-rated** bonds in the US, while within high yield we still think that there is room for further compression in yields in the US.


Chart 2: current yields across global fixed income markets


Source: Bank of America Merrill Lynch, Bloomberg, Janus Henderson Investors, as at 8 November 2017.
Note:     Yield to worst for corporate bonds; generic 10-year yields for US Treasuries, German bunds and UK gilts.


The theme we expect to play out in 2018 is that the global economy will continue to do well. Defaults will likely continue to be low, so we favour higher yielding credit on a relative basis. The key will be to continue to be selective and remain disciplined with late-cycle conditions evident in the level of dispersion between sectors. This is magnified by significant technological and industry changes impacting certain industries and reflected in our approach of avoiding certain sectors altogether. It also drives our belief that being index agnostic ultimately helps our investors. 

The extent of current levels of dispersion in valuations within high yield and investment grade are shown in charts 3 and 4 below. The charts reveal a much higher level of dispersion within high yield but less so for investment grade given its higher quality (eg, lower levels of leverage).

To illustrate, high yield corporate bond spreads in sectors with percentile ranking of 50 and above, are now wider than their historical average spread (over the period from 2000 to now), which is indicative of sector issues, but 13 of the 20 sectors are trading in the bottom quartile (tighter spreads than their historical average).

We expect high yield dispersion to remain elevated and this should benefit us as opportunities present themselves for credit picking.


Chart 3: high yield bond valuations — ranking by sectors



Source: The Yield Book Inc, FTSE Index, Goldman Sachs Global Investment Research, Janus Henderson Investors, as at October 2017.
Note: Percentile ranks for high yield sector level spread averages. Data spans the period from 2000 to now.


Chart 4: investment grade bond valuations — ranking by sectors


Source: The Yield Book Inc, FTSE Index, Goldman Sachs Global Investment Research, Janus Henderson Investors, as at October 2017.
Note: Percentile ranks for investment grade sector level spread averages. Data spans the period from 2000 to now.


An additional point to note is that we have seen money flowing into alternatives, with investors chasing returns. These alternatives are often complex investment structures promising higher returns to compensate for the lower liquidity available versus traditional fixed income instruments. A lot of these strategies are unproven and the depth of liquidity in these markets is quite shallow. We still think investing in the relatively liquid developed world fixed income markets is a better way to seek to deliver superior risk-adjusted returns to our investors.

Summary
The questions we are currently being asked by investors are very valid. At a valuation level, while many high quality credits are trading at fairly expensive levels, in our view they are justifiable taking into account our macroeconomic outlook and the quality of the issuers. Further, given the need for income, we remain overweight high yield and the lower end investment grade corporate bonds.

In summary, we believe that the value proposition for investing in fixed income assets remains intact.



*10-year US Treasuries yield around 2.3%, as at 6 November 2017. 
** Credit rating score by credit rating agencies such as Standard & Poor’s. A BBB rating represents relatively low risk bonds and is towards the bottom of investment grade bond ratings.

 
Alternatives: an investment that is not included among the traditional asset classes of equities, bonds or cash. Alternative investments include property, hedge funds, commodities, private equity and infrastructure.

Bond:
a debt security issued by a company or a government, used as a way of raising money. The investor buying the bond is effectively lending money to the issuer of the bond. Bonds offer a return to investors in the form of fixed periodic payments, and the eventual return at maturity of the original money invested – the par value. Because of their fixed periodic interest payments, they are also often called fixed income instruments.

Bond yield:
the level of income on a security, typically expressed as a percentage rate. Note, lower bond yields mean higher prices and vice versa.

Coupon: a regular interest payment that is paid on a bond. It is described as a percentage of the face value of an investment. For example, if a bond has a face value of £100 and a 5% annual coupon, the bond will pay £5 a year in interest.

Credit: corporate bonds.

Default: the failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.

Inflation: the rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures.

Investment grade/high yield: a bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high yield bonds.

Late-cycle: asset performance is often driven largely by cyclical factors tied to the state of the economy. Economies and markets are cyclical and the cycles can last from a few years to nearly a decade. Generally speaking, early cycle is when the economy transitions from recession to recovery; mid-cycle is when recovery picks up speed while in the late cycle growth slows, wages start to rise and inflation begins to pick up. At this stage, investors become invariably bullish believing that prices will continue to rise.

Liquidity: the ability to buy or sell a particular security or asset in the market. Assets that can be easily traded in the market (without causing a major price move) are referred to as ‘liquid’.

Spread: the difference in the yield of corporate bonds over equivalent government bonds.

Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment.

Yield to worst: if a bond has special features, such as a call (ie, the issuer can call the bond back at a date specified in advance), the yield to worst is the lowest yield the bond can achieve.
 

 

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

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Janus Henderson Fixed Interest Monthly Income Fund

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Specific risks

  • Some or all of the Annual Management Charge and other costs of the Fund may be taken from capital, which may erode capital or reduce potential for capital growth.
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  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
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