Fixed Income Outlook: Catching Summer Yield Waves
Three SPDR® fixed income ETF implementation ideas for the upcoming quarter.
Theme 1: Riding Summer Carry with High Yield
- Given the persistence of the solid growth backdrop, we believe it makes sense to retain an allocation to high yield. High yield typically provides strong returns during the July-to-August period, in part due to the carry advantage during those months.
The second quarter proved to be considerably more friendly to fixed income investors than the first. Yields on the US 10-year fell around 25bp from the highs seen at the end of March 2021, allowing strategies that we suggested in the Q2 Bond Compass, such as US investment grade (IG) credit, to make solid returns of 3.5%.1
As the Global Market Outlook suggests, the backdrop for markets is expected to remain supportive of risk assets. Growth remains strong, driven by still-accommodative monetary policy, highly expansive fiscal policy and pent-up consumer demand. This is not an especially constructive backdrop for many of the lower risk elements of the fixed income universe, but there are several mitigating factors, including:
- Overall macro pressures should start to ease, with inflation expected to fall back. Meanwhile, growth will remain strong but looks unlikely to exceed some already high forecasts. For instance, the Federal Reserve (Fed) estimates US growth of around 7% for 2021.
- Summer markets are often favourable for bonds. The average yield decline for the 10-year US Treasury has been 16bp over the July-to-August period, based off a 10-year history.
- Market participants have now been primed for the taper discussion. While markets inevitably do not like the withdrawal of easy monetary policy, the June FOMC meeting was a warning shot that policy settings will need to change. The Fed funds futures now price the first rate rise by the end of 2022, with 50bp of tightening included over the coming two years.
While the pricing of markets should provide some protection to a renewed sell-off in fixed income, inflation remains a key risk. The PriceStats® measure of US inflation suggests that it may be slow to decline, which risks unsettling the longer end of the curve where yields are well below their end of Q1 peak,2 largely driven by the assumption that the Fed will not be as tolerant of inflation as initially feared.
There are also some downside yield risks: the Delta variant of COVID is spreading fast. However, vaccination programs seem to be working with the UK, for instance, still recording a low death toll despite a surge in infections. This points to a low risk of renewed lockdowns but restrictions on things like travel could remain a drag on GDP.
On balance, upside yield risks still dominate, which makes us wary of long-duration assets. At the same time, seasonality does typically favour being long bonds over the summer. Figure 1, which shows the five- year average returns for various fixed income indices over the June-to-September period, illustrates this point well.
Figure 1: Seasonal Returns – 5-year Average Returns During the Summer
Retain Allocations to High Yield
High yield was a theme in the Q2 Bond Compass and it has performed strongly — US high yield in particular.3 Given the persistence of the solid growth backdrop, we believe it makes sense to retain an allocation to this asset class. High yield typically provides the greatest returns of the strategies shown in Figure 1 over the July-to-August period, in part due to the carry advantage during those months.
US high yield is also one of the few strategies that does not tend to endure a September reversal. It also typically has a shorter duration than IG due to high coupons and high yield issuers having a preference for shorter maturity bonds. This should limit the impact on returns if inflation does not drop as the market anticipates.
Spreads are tight by historical standards but the still relatively high outright yields coupled with the short duration of the indices could allow investors to absorb some spread widening if current spreads prove unsustainable. There are fears that default rates may rise as government support measures start to get unwound. However, a significant deterioration in the credit quality of issuers still appears some way off.
Favourable funding conditions remain in place with low yields and solid demand for non-investment grade rated paper. This, coupled with the strong rebound in growth, should see earnings well supported. The Moody’s Upgrades to Downgrades ratio for high yield issuers in North America hit 3.1 in Q2, the highest in the history available back to 2011. For Europe, the ratio is 2.26, the highest since Q3 2017. So a deterioration in credit quality may not be a near-term concern unless growth slows sharply.
How to Play this Theme
SPDR® Bloomberg Barclays Euro High Yield Bond UCITS ETF
SPDR® Bloomberg Barclays 0-5 Year US High Yield Bond UCITS ETF
Theme 2: Emerging Market Local Currency Debt — Cause for Optimism
- After a rough start to 2021, emerging market debt seems to have settled down as the Fed has downplayed fears of a rate rise. We see a few key reasons to be positive on emerging market debt local currency, including yield, undervalued FX and the proactive approach of EM central banks.
The first half of 2021 saw some pitfalls for investors in emerging market (EM) debt. The first three months of the year delivered negative returns as the snap higher in US Treasury yields and the USD, coupled with rising COVID infection rates in EM, saw investors turn cautious on EM assets.
There was a bounce-back in returns in April and May, driven largely by a currency rebound, as investors saw EM catching up with the growth recovery in the G10. However, the FOMC meeting proved a challenge, as it brought back memories of the taper tantrum, in which EM debt fared poorly, and there was a spike in the USD. Markets have settled with the Fed downplaying expectations that rates will rise soon. EM debt has posted a partial recovery and we see several reasons for investors to be positive on local currency debt.
Figure 2: Bloomberg Barclays EM Local Currency Liquid Govt Index Returns
Yield Appeal
The Bloomberg Barclays EM LC Liquid index has a yield-to-worst of more than 4.4%, its highest since March 2020.4 This is well above the 3.7% yield of the Bloomberg Barclays US Corporate High Yield Bond
Index, which is close to all-time lows.5 Figure 2 shows the decomposed returns of the Bloomberg Barclays EM Local Currency Liquid Government Index, and we see 30-40bp of coupon returns that accrue monthly. With investors seeking returns in a low yield environment, this is quite a draw. The appeal of yield may increase in the summer, when investors like to lock in trades with strong carry credentials.
FX Undervalued
Figure 2 underlines that the largest factor determining returns in Q2 was the currency. As at the end of June 2021, the basket of currencies that make up the Bloomberg Barclays EM Local Currency Liquid
Government Index was 4.5% undervalued against the USD, according to the State Street Global Advisors long- term model of fair value. The US is running twin deficits, which have in the past been a catalyst for a weaker USD and, in addition, higher levels of inflation will typically undermine the longer-term value of a currency.
Pushing the USD in the opposite direction is the idea that the Fed could start to raise rates (hence the 2% appreciation in the DXY trade-weighted USD around the FOMC meeting). While this is the case, some EM central banks have already entered the tightening cycle. Turkey got the ball rolling in 2020 but it has been followed by Brazil, Hungary, Russia and the Czech Republic. This should support those countries’ foreign exchange rates both because of the changes in interest rate differentials and because it supports the credibility of the central banks involved.
EM Central Banks Ahead of the Curve
A rising interest rate environment is not usually conducive to buying bonds but, in this case, there are several reasons why its impact could be limited. Raising rates to dampen inflation could be constructive for the longer end of the curve — witness the rally in the 30-year US Treasury as the Fed was perceived to be less complacent on inflation risks. Tighter monetary policy is more damaging for short maturities but there is evidence that the market is already priced for a material tightening.
Figure 3 shows the slope between the central bank rate and the 2-year bond yield weighted to be consistent with the Bloomberg Barclays EM Local Currency Liquid Government Index. As such, this represents the degree of monetary tightening that is anticipated in these markets in the coming years and it is back at the highs seen in 2018, which was the last time there was a general tightening by EM central banks.
Figure 3: Front End Slope in EM Already Factors in Higher Central Bank Rates
Unusually low central bank rates mean that the 0–2-year spread can potentially stretch a little higher than previous peaks, but the slope already looks extended and is liable to revert to more average levels at some stage. This may be driven by policy tightening delivering what is priced into the curve or because expectations of tightening prove overblown and start to fade.
Figure 3 also shows weekly rolling 3-month/3-month returns of the Bloomberg Barclays EM Local Currency Liquid Government Index on an inverted scale. Historically, sharp moves higher in the front end spread have been negative for index returns but if the 0-2-year spread starts to narrow from current stretched levels, then this has been consistent with improved returns from EM debt.
How to Play this Theme
SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (Dist)
SPDR Bloomberg Barclays Emerging Markets Local Bond USD Base CCY Hdg to EUR UCITS ETF (Acc)
Theme 3: Convertible Bonds for Risk-On Markets — or for Defensive Attributes
- For investors looking to capture rising equity markets while taking some risk off the table, convertible bonds could be a suitable approach. With convertibles, investors can seek to avoid regional weakness, take advantage of long-duration characteristics, and reduce concentration risks.
The riskier segments of the fixed income market posted strong gains in Q2. Convertible bonds, which are the most equity-like of the fixed income strategies, did well as the Refinitiv Qualified Global Index gained 3.24%.6 With the strong growth backdrop forecast to persist and inflation pressures expected to abate, equities could continue performing well*. With the delta of the Refinitiv Qualified Global Index at over 63%, off its recent peak but still high historically, equity market strength should underpin further gains in convertibles.
Figure 4: Sector Distribution and Average Delta
Defensive Qualities of Convertible Bonds
While equities are expected to push higher over the summer*, equity investors may want to take some risk off the table by switching into convertibles, where the bond floor provides a degree of protection in the event of a correction. It is worth noting that some of the names that had driven the rally earlier this year lost a bit of their froth at the end of Q1 and appeared more attractively valued going into Q3.
Even for fixed income investors there are reasons to see convertible bonds as a more defensive play
and, potentially, a little less dependent on the fortunes of equity markets than the raw delta might suggest. Meanwhile, the implied volatility, standing at 34% in the portfolio, has fallen back close to long-term averages. This suggests a more affordable hedge, as our Global Market Outlook recommends approaching markets with a kernel of caution. We see three key defensive qualities for investors to consider.
- Avoid regional weakness The Refinitiv Qualified Global Index skews heavily toward US paper (53.5%) but is nonetheless a global index, which should dilute the impact of regional weakness. This helps in an environment where COVID has typically seen whole countries lock down. While vaccination now provides meaningful protection, not all areas have achieved the critical vaccination rates to allow a general re-opening. And there is always a risk that new variants prove resistant to the current vaccines.
- Long-duration characteristics The Refinitiv Qualified Global Index has a heavy bias toward tech issuers (see Figure 4). This area has a high delta and has performed well recently on the bull flattening in the long end of the US curve, as inflation expectations have subsided. In other words, tech is considered a ‘long-duration’ asset7 that should perform better now that inflation is seen as having peaked and the Fed potentially has a less laissez-faire attitude than originally thought. If another lockdown takes hold, this combination of the long-duration characteristics of tech, plus the fact that the sector is favoured by any increase in working from home, should see this element of the index perform well.
- Reduce concentration risks Tracking a broad index helps to reduce concentration risks. Figure 5 shows the top 20 funds that invest in convertibles and it highlights potential liquidity risks. The size of the fund is no guide to the number of securities held, with the largest fund in the group having half the number of the second largest.8 In terms of concentration risk, six of the 20 funds have more than 30% of their exposure in just 10 holdings, which is high relative to the (unweighted) average for the group of 23.3%. The SPDR convertible bond ETF is the 7th largest fund and has fairly low levels of concentration, with the highest number of holdings in its peer group and just 14.1% of assets in its top 10 holdings (Source: Morningstar as of 31 March 2021).
Figure 5: Concentration Risks in the Top 20 Largest Convertible Funds
Issuance of close to US $100 billion for H1 2021 has also helped to increase the diversification of the universe. In June, Etsy Inc and Cheesecake Factory were among the names that came to the market for funding.** This has diluted the impact of certain high delta and large names in the universe, such as Tesla, falling from the maximum of 4% going into 2021 to c. 1.25% as of quarter end.**
If the strong growth environment persists, convertibles should continue to gain on the back of rising equities. However, this should not be viewed as a pure risk-on strategy: the global and diversified nature of the Refinitiv Qualified Global Index should limit volatility versus its peer group while a meaningful allocation to the tech sector could limit the fall-out of any renewed threat to the global economy from COVID.
How to Play this Theme