Investor Sentiment: Fixed Income Flows and Holdings

State Street Global Markets builds indicators of aggregated long-term investor behavior in fixed income markets from a substantial subset of $10T of fixed income assets under custody and administration at State Street.*

This reflects behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.

Analysis
The uncertainties that had dogged the outlook for much of 2019 came to a head in Q4, leaving an apparently cleaner slate for 2020. A truce was tentatively agreed to in the US-China trade war, Brexit cleared another hurdle with Boris Johnson’s resounding election victory, and recession risks ─ both in the US and elsewhere ─ appear to have declined.

The principal response across fixed income markets was a fall in precautionary demand for US Treasuries; inflows appear on track to record a six-month low. Treasuries were not abandoned completely though, with much of the selling concentrated at the long end of the curve. Investors are anticipating a continued steepening in the curve in 2020. This is additional proof that recession risks are dissipating, as is the recovery in demand for high-yielding corporate debt in spite of the rash of credit downgrades and the lateness of the credit cycle.

It was not all good news, though, as the elimination of the underweight holdings in Italian and emerging market sovereign bonds was interrupted in Q4. Local currency emerging market debt in particular may have been expected to be the destination of choice for more risk-seeking investors, but the nascent return of inflation and lower real yields are giving investors pause for thought.

The Long Drain on Treasuries
Given the broader background of reduced tail risks, it is not surprising to see precautionary demand for Treasuries weakening over the quarter. Long-term investor demand on a duration-weighted basis fell into the 33rd percentile across the quarter, the weakest reading in six months.

It would be wrong, however, to suggest that investors have abandoned Treasuries altogether. Much of the weakness in demand was at the long end of the curve, with demand for Treasuries with a duration in excess of 10 years slipping into the 13th percentile. Demand for short-dated Treasuries was more or less unchanged and remains robust relative to history. The implication is that investors appear to be anticipating a further steepening in the US yield curve, which is consistent with expectations of steady growth and a lower risk of recession.

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Source: State Street Global Markets as of December 31, 2019.

Credit Questions
Amidst the recession concerns that ebbed and flowed for much of 2019 – in addition to the record length of the current cycle – US high-yield credit has required careful observation. It is perhaps telling, then, that demand for high-yielding corporate debt ended Q4 at a two-year high. Digging further into where net inflows occurred shows solid demand all the way across the high-yielding rating spectrum, as well as an acceleration of inflows in December. This may be understandable given the reduction in aggregate recession risk, but the sheer strength and breadth of flows are surprising given the rash of high-yield credit downgrades during the quarter; there were 1.86 downgrades for every upgrade, according to Moody’s.

It is also worth noting that such robust demand for credit was not limited to the US. Demand for European corporate bonds rose to a five-year high during the quarter. While this could be interpreted as simply an outright rush for yield, that does not quite fit with the observed behavior, as not all high-yielding sovereign bonds saw inflows over the quarter.

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Source: State Street Global Markets as of December 31, 2019.

Eurozone Runs
A persistent theme in the Bond Compass publications of the past year has been the steady demand for Italian sovereign debt. For more than a year, investors have been unravelling their underweight position in Italian bonds, even in the face of questionable fundamentals. The fiscal challenges of Italy’s debt burden and barely growing economy had not changed significantly, but the lure of higher yields and promise of ECB buying proved too much. However, Q4 data suggests that Italian yields have finally levelized.

Inflows into Italian government debt have begun to dry up, and there have even been pockets of selling in December, which suggests that one of the stronger fixed income trades of 2019 is unlikely to be as attractive in 2020. Meanwhile, demand for Spanish debt will require close observation as the new Socialist government – backed by the radical left-wing party Podemos – attempts to pass its first budget. Investors are already underweight Spanish debt, and recent flows suggest no sign of panic yet.
 

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Source: State Street Global Markets as of December 31, 2019.

An Emerging Surprise
As with Italian sovereign debt, long-term fixed income investors began 2019 with a significant underweight in emerging market debt. However, global trade war concerns, alongside a range of country-specific risks, have consistently restrained the return to emerging sovereign markets. Nevertheless, with the apparent reduction in tail risks over the quarter, it was surprising to see long-term investor demand for emerging bonds actually fade at the end of the year.

It is possible that the trade truce came too late in the quarter to rescue sentiment, although we did not see any real improvement in demand in December. Further, it is notable that the weakness in demand was relatively broad based. Our regional flow aggregates showed soft demand across Latin America, EMEA and APAC. This does beg the question whether real yields remain attractive enough to entice investors back into local currency emerging market debt or whether emerging market equities are a better opportunity to play the potential trade truce. Moreover, emerging market inflation trends are just beginning to look a little less friendly in places.

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Source: State Street Global Markets as of December 31, 2019.

Footnotes

*Source: State Street Global Markets, as of December 31, 2019.

Disclosures

The commentary does not take into account any investor’s or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

The units of the Sovereign Bond Flow Indicators are standardized by debt outstanding at each point in the curve and then for the aggregates are duration weighted. State Street Global Markets then aggregates the indictors into percentiles to gauge the significance of a flow or positioning metric over a variety of time periods and countries. State Street Global Markets’ use is aimed at being a simple way of ranking flow and positioning indicators relative to their own history. For all of the flow indicators within the Bond Compass, State Street Global Markets calculates the percentiles based on the distribution of flows over the last five years using the daily aggregate time periods shown in the charts. As a guide a 100th percentile reading represents the strongest buying in five years; and a zero percentile equals the strongest selling. A reading in the 50th percentile would signal that net flows in the asset over the period are at their average level, typically close to zero.