17 February 2020
The market cannot decide whether it wants to be risk-on or risk-off, as equities hover not far from their highs and US Treasury yields are back down close to their lows. The market’s split personality owes a lot to the uncertainty surrounding the coronavirus, with the verdict still out on the degree to which it will affect growth.
Market participants also seem to be drawing some comfort from the fact that central banks remain in policy-easing mode in order to insulate their domestic economies from the potential impact of a China slowdown.
One way of limiting exposure to large swings in risk appetite is to focus on income. In the last Strategy Espresso we highlighted the potential benefits of the Dividend Aristocrats equity ETFs, but in the world of fixed income it is non-investment grade high yield bonds that provide one of the strongest income streams. There are several reasons to value this income stream in an uncertain world:
- Coupon protection: A high coupon means that investors will be less dependent on movements in the underlying asset to generate returns. Figure 1 illustrates the degree to which coupons can supplement total return or, in the case of 2018, help to offset the effects of falling bond values.
- A growth recovery would be supportive: High yield correlates far more closely to equities (73% on 10 years of monthly data) than to government bonds (14%), suggesting high yield sits squarely in the class of risk assets. Indeed, history indicates that spreads to government bonds have typically tightened as economic growth has improved. In addition, the high coupon typically means that the duration of bonds is relatively short compared to their investment grade equivalents. This makes high yield an interesting defensive play if there is a V-shaped economic recovery and fixed income yields start to rise.
- Slowing growth not damaging, as long as no recession: In the event of weaker growth, bonds should be somewhat insulated in light of expectations that interest rates will remain low for an extended period, which will support all fixed income. The ECB should also continue its asset purchase programme, which, while focused on investment grade bonds, may have some spill-over support for non-investment grade bonds. The key risks come from recession and an accompanying rise in default risk. This would be damaging to high yield bonds but is not the expected scenario according to State Street Global Advisors Economics.