Fixed Income Outlook: Barbell Credit with Defensives for Yield and Durability
Three fixed income implementation ideas for the upcoming quarter.
Theme 1: High Yield - Keep Calm and Keep the Carry
- High yield has been a cornerstone of returns for fixed income investors in 2021 year to date. Returns were even positive in Q1, when US Treasury yields shot higher. The powerful stabilising supports of spread compression and generous coupon payments are reasons why high yield has been an investment theme in each Bond Compass for 2021.
The recent wobble in equities has seen high yield spreads widen. However, risks of a material widening look limited by the still strong growth dynamic. While the pace of growth is starting to slow, it is expected to remain firmly in positive territory into 2022, which should also see earnings well supported. Additionally, supply bottlenecks should eventually ease and labour may become more plentiful as government support schemes end. It should be no surprise that recent ratings upgrades have been skewed towards positive outcomes, with US high yield companies seeing an upgrades/downgrades ratio of above 2.5 over the last 2 quarters for both the Moody’s and S&P1 ratings agencies.
Learning to live without the Fed
The other uncertainty is the effect that the reduced level of bond purchases by central banks will have on high yield bonds. Neither the Federal Reserve (Fed) nor the European Central Bank (ECB) buy high yield bonds but, if underlying yields are forced higher, then returns will still suffer. However, the impact of slowed central bank buying on fixed income returns is by no means mechanical even for government bonds.
The 2014 tapering of purchases by the Fed and the impact that had on the 10-year US Treasury yield and the option-adjusted spread of the Bloomberg US Corporate High Yield Bond Index is shown in Figure 1. Treasury yields actually rose in advance of the taper, peaking just shortly after its start. They then declined over the rest of the period when bond purchases were phased out. In high yield, there was actually a tightening in the spread to Treasuries over the first 6 months of the tapering, largely because economic growth momentum remained strong. Notably, monthly returns from US high yield indices were positive between September 2013 (i.e. once the mid 2013 taper tantrum had subsided) until July 2014 (asset purchases ended in October 2014).
Figure 1: Navigating the Federal Reserve Taper with High Yield
While any historical comparison comes with a warning that things are different this time, the preceding example does highlight the resilience of high yield returns due to their high coupon payments and short duration. With spreads having widened, their ability to absorb any rise in underlying Treasury yields may be more limited this time around but there could still be scope for this as long as growth remains firm.
European high yield bonds should be less affected by central bank actions than the US. The ECB has noted that it will purchase fewer bonds in Q4 but, unlike the Fed, it has announced no estimated target date for the cessation of purchases. This should ensure a more stable performance from government bonds. In addition, spreads on European high yield are not as tight from a historical perspective as those in the US. For instance, the option-adjusted spread on the Bloomberg Liquidity Screened Euro High Yield Bond Index remains more than 120bp wider than the tights reached in 2017, while the US high yield spreads remain closer to their lowest levels since 20032.
Both US and European high yield still offer appealing levels of yield and relatively short durations. While we expect that the Fed’s Taper will not cause a major spike in Treasury yields, defensive duration positions mean a limited impact on performance if yields do push higher.
How to Play this Theme
SPDR Bloomberg Barclays Euro High Yield Bond UCITS ETF
SPDR Bloomberg Barclays 0-5 Year U.S. High Yield Bond UCITS ETF
Theme 2: Emerging Market Debt Left Out in the Cold
- Emerging market debt had a volatile first three quarters of 2021. Returns have been weighed on by concerns around COVID, high inflation forcing central banks to tighten policy, and a resurgent USD. Fears over the upcoming Federal Reserve taper have done their bit to keep investors on the sidelines.
The first half of 2021 saw certain 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.
The end result is that, currently in the broader market where credit spreads have compressed, yields on EM debt remain at relatively normal levels from a historical perspective. The yield to worst on the Bloomberg Emerging Markets Local Currency Liquid Index is 4.90% in line with the 5-year average. The obvious comparison is with developed market high yield strategies and, for the Bloomberg US Corporate High Yield Bond Index, the current yield of 4.20% is well below 5.80% 5-year average. Indeed, the spread between these two indices is 70bp, against a 5-year average of -85bp.3
Aside from the appeal of a higher yield, there are reasons to expect long-term returns from EM debt; see Emerging Market Debt: Unfulfilled Potential for a more in-depth discussion on the below.
- Signs that inflation may be starting to top out (or at least moderate over the coming six months, as suggested by PriceStats®) should relieve some pressure on EM central banks to raise rates. Indeed, there are already signals that momentum in central bank policy tightening may be starting to turn. Figure 2 below shows the balance of central banks raising rates versus cutting them for the 19 central banks in the Bloomberg Emerging Markets Local Currency Liquid Index. While the 12-week average is now in positive territory, it has started to decline. With a significant amount of policy tightening already priced into the curve4 , signs that inflation pressures are easing could result in a flatter profile for future interest rate rises, which in turn would support bonds.
- As at the end of September 2021, the USD was expensive versus EM FX. The model of the long-term value of currencies, as run by State Street Global Advisors, calculates that the USD was 7.6% expensive to the basket of currencies that makes up the Bloomberg Emerging Markets Local Currency Liquid Index. This is its richest level in a year.
The above factors support EM debt. There are no guarantees that this scenario will play out during the coming quarter but there could be some potential triggers for better performance. EM debt investors have been nervous of Fed actions since the 2013 Taper Tantrum hit returns, so weaker economic numbers, pushing out the date of the taper, may support risk appetite. Alternatively, if the Fed starts to cut its bond purchases and the markets react favourably, fears of an aggressive back-up in Treasury yields and spike in the USD would diminish. Damping concerns over USD strength, in particular, should bolster investor confidence in EM debt returns.
Figure 2: EM Central Bank Hike/Cut Momentum is Starting to Turn
The China Factor
A key support for EM debt should continue to come from China. Making up around 10% of the Bloomberg Emerging Markets Local Currency Liquid Index, Chinese bonds have turned in the strongest performance of any country bonds year to date, returning 5.8%.5 Chinese bonds are a useful risk diversifier, often not behaving like the majority of EM bonds. This was evident during the peak of the COVID crisis and has continued to be the case, with local Chinese bonds actually rallying in Q3 on the back of the deteriorating growth outlook as the September manufacturing PMI dropped below 50. There is a feeling that the People’s Bank of China will continue to focus on adding liquidity rather than cutting rates at this juncture. However, wider contagion from the problems at Evergrande, coupled with persistent weakness in economic indicators, may cause the market to speculate on the possibility of a rate cut.
The CNY has also contributed to positive returns year to date, which is unusual in the context of the USD rally seen in 2021. Some support for the currency would have come from the favourable flow story of Chinese bonds. Data from the Institute of International Finance suggests that just over 50% of the $200 billion of foreign investment flows into EM debt seen so far in 2021 have moved into Chinese bonds.6 Overseas investment is expected to continue with the expansion of the FTSE World Government Bond Index (WGBI), which is set to include China from October 2021.
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: US Investment Grade Credit - Barbelling Risk to Add Durability
The first two investment themes revolve around staying invested in high yield and EM debt. Both strategies offer yields well in excess of those from government bonds, which provides investors with some protection. However, both could be vulnerable if the broader market goes risk-off, pushing equities lower. This is not a central view: State Street Global Advisors expects firm economic growth into 2022 to support risk appetite. Nonetheless, there are several reasons for fixed income investors to be cautious:
- Year-end market issues: Challenging market liquidity conditions sometimes occur as year-end approaches. These conditions could be exacerbated if central banks ease back on policy support measures.
- Growth slowdown: Some recent data has hinted that growth momentum is starting to fade. The PMIs in most of the key economies have come off their highs and logistical issues continue to hamper the reopening of the economy. There are particular issues in China, where a more meaningful slowing could heighten fears that global growth in 2022 will not be as robust as is currently expected.
- Short squeeze: Lower-than-benchmark duration exposure is a natural position to take if expectations are that bond yields will go up. The post-September FOMC rise in Treasury yields is likely to reinforce underweight market positioning. However, with yields a little higher, and if growth momentum does start to slow, there is the risk of a scramble to push durations back to more neutral levels.
As a consequence, we like to balance these higher risk strategies with US investment grade (IG) exposure. IG spreads to government bonds are historically tight at around 80bp.7 Even though spreads can be expected to widen if economic indicators start to slow in a more meaningful way, the additional duration of the IG exposure should ensure positive returns as underlying bond yields decline.
Taper Ahead
The risk is clearly that high inflation prompts central banks to exit policy stimulus more rapidly. However, using the example of the Fed’s actions in 2014 (the only real example of a taper that we have), it is clear that investors would have received higher returns from being invested in IG credit than in Treasuries.
Figure 3 shows total returns from the Bloomberg US Corporate Bond Index and the Bloomberg US Treasury Index during and around the 2014 taper. While there was a little more volatility from the IG credit index in the run-up to the Fed taper, once the process got underway, returns from IG were considerably higher than for Treasuries. Some of this performance was the result of the longer duration of IG credit but this was limited given the yield to worst on the Treasury index fell by less than 10bp during the taper. The stronger performance of IG credit was more about spread compression coupled with the higher coupon on credit versus government bonds than moves in rates.
Figure 3: IG Credit Posted Stronger Total Returns During the 2014 Fed Taper Than US Treasuries
Additional protections
An additional layer of defence can come from incorporating ESG into your portfolio. This is becoming an increasingly popular approach with investors. One key reason is the potentially higher degree of stability provided by ESG strategies, as discussed in US Investment Grade Credit: Stability Through ESG. This note illustrated that the Bloomberg SASB ESG US Corporate Ex Controversies Select Index performed better during the peak of the COVID Crisis than the standard Bloomberg US Corporate Index. Our analysis highlighted the benefits of ESG screening for index stability and longer-term index performance versus the traditional market weighted index. So there are grounds to believe that ESG integration could help dampen volatility around the start of the Fed’s taper.
We have focused on US IG strategies given the yield that they provide, with a pick-up of over 180bp versus a similar European IG corporate strategy.9 While the carry will be appealing, currency risks cannot be ignored, not least given the recent appreciation of the USD. As such, for euro-based investors, it may be worth considering a EUR-hedged strategy to remove the drag on performance if the USD does start to weaken.
How to Play this Theme
SPDR® Bloomberg SASB U.S. Corporate ESG UCITS ETF (Acc)
SPDR® Bloomberg SASB U.S. Corporate ESG EUR Hdg UCITS ETF