Insights
Defensive Duration Until Inflation Clouds Clear
The backdrop of strong growth and questions over how the inflation story plays out mean we continue to lean toward short-duration/high-yielding strategies such as EUR and USD high yield and emerging market hard currency.
The question of inflation
The question of the moment, for investors, is inflation. Central banks’ rhetoric clearly suggests a view that the spike in CPI is the transitory impact of higher commodity prices and temporary distortions from impaired supply chains all acting on unfavourable base effects. However, market participants seem less convinced and appear unsettled by the apparent complacency of central bank officials.
While base effects will act to draw CPI lower during the second half of the year, there remain some pretty powerful forces acting in the opposite direction, not least the massive monetary and fiscal stimulus that continues to feed the demand side of the economy. Supply chains are not yet back to normal and, as a result, many surveys point to strongly rising prices.
The derived 1-year 1-year forward rate of US inflation (Figure 1) has come off its highs, suggesting the market is a little more sanguine that recent upside surprises have run their course.1 However, the implied rate remains around 2.5%, which is in the range seen prior to the 2008 financial crisis rather than the post-crisis norm.2 If inflation does prove more persistent than is widely believed, then there could be another leg higher for US yields. Indeed, European yields have also been rising, playing catch-up to their US counterparts as the better economic news gets priced into its bond market.
Implied 1-Year Rate of Inflation in 1 Year
Source: State Street Global Advisors, Bloomberg Finance L.P., as of 20 May 2021.
The backdrop of strong growth and questions over how the inflation story plays out mean we continue to lean toward short-duration/high-yielding strategies such as EUR and USD high yield and emerging market (EM) hard currency (see the Q2 2021 Bond Compass for details).
- These strategies have performed well year to date, limiting the impact on performance of rising government yields through their short-duration exposure. For instance, the Bloomberg Barclays 0-5 Year U.S. High Yield Bond Index has an option-adjusted duration of just 1.82 years, meaning its price sensitivity to rising rates is less than 1/4 of that of the Bloomberg Barclays U.S. Corporate Bond Index.
- Even in the event that inflation proves transitory, it is hard to see a meaningful rally in global rates given the strong growth backdrop and still extremely high levels of government issuance. Limits to capital appreciation means focusing on yield for returns. US high yield bond funds typically deliver in excess of 3% yield to worst, while the Bloomberg Barclays Euro High Yield Bond Index and the ICE BofA 0-5 Year EM USD Government Bond Index both have a yield to worst of more than 2%.3
- The high yields on offer mean that these ‘risk assets’ have a spread to the government bond curve and this proved an effective shock absorber to higher underlying yields. For example, the Bloomberg Barclays Euro High Yield Bond Index started 2021 with a spread of around 325bp, which has subsequently narrowed to 290bp, meaning around 35bp of the rise in government yield was absorbed by spread compression.
The clear counter-point to this is that spreads are tight on a historical basis and that equates to low levels of compensation for credit risk. Widespread policy and legislative support for companies throughout the COVID pandemic has resulted in very low bankruptcy rates. This justifies tight current spreads but there are risks that these rates start to rise as supportive measures are gradually peeled back. However, strong economic growth should create a positive backdrop for earnings, which have been strong, while the low rates and demand for higher-yielding credit have allowed even some of the lowest-rated companies to engage in balance sheet strengthening.
The coming few months will hopefully see the clouds surrounding the inflation outlook clear. Until there is more certainty that inflation will indeed revert to levels more consistent with what central banks view as sustainable, upside yield risks exist for fixed income markets. With this in mind, remaining short duration should provide a degree of protection to investors, with returns coming from yielding strategies such as high yield and EM debt. This approach entails credit risks but the global backdrop of strong growth, which could spread to EMs as vaccination rates rise, should act as a stabiliser.
US Bankruptcies Have Fallen Back
Source: Bloomberg Finance L.P., as of 21 May 2021.
How to play these themes
Investors looking to access the themes described above can do so with SPDR ETFs. To learn more about these ETFs, and to view full performance histories, please click on the linked fund names below.
SPDR® Bloomberg Barclays 0-5 Year U.S. High Yield Bond UCITS ETF (Dist)
SPDR® Bloomberg Barclays Euro High Yield Bond UCITS ETF (Dist)
SPDR® ICE BofA 0-5 Year EM USD Government Bond UCITS ETF (Dist)
European-Domiciled ETP Segment Flows (Top/Bottom 5, $mn)
European-Domiciled ETF Asset Category Flows ($mn)
Source: Bloomberg Finance L.P., for the period 13-20 May 2021. Flows are as of date indicated and should not be relied upon as current thereafter. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future.