Government Bonds: 2015 – The Year Of Living Carefully? by ColumbiaManagement
- We expect high yield and emerging markets debt to deliver better returns in either a slow growth or inflationary recovery scenario.
- Investors should brace for higher levels of price volatility as monetary policy continues to move in different directions around the globe.
- These divergent outcomes suggest the benefits of pursuing an active approach in fixed income markets.
Following a year in which global government bonds generated total returns of over 8% (currency hedged), it is difficult to imagine that returns will be as strong in 2015. Yields are very low both in historical terms and in relation to present and expected rates of inflation, yet dangers persist, both geopolitical and economic. Meanwhile, value may exist in some areas in which risk premiums, or spreads, have risen over the past year and demand is likely to remain firm.
We have identified several themes within the fixed income market:
Investors may be complacent about the outlook for interest rates in 2015
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Central bank policy has supported global markets with the combined balance sheet of the G4 central banks expanding massively in recent years. Meanwhile, market expectations of where interest rates will be by the end of 2015 have moved meaningfully lower from where they were a year ago. Indeed, it is getting hard to imagine that investors could become any more dovish about prospects for interest rates. Thus, markets are discounting one rate increase in the U.S. by the end of 2015, and no rate increases in the UK until mid-2016. Nor is any move expected in the eurozone or Japan.
Exhibit 1: Market expectations of interest rates at the end of 2015
Sources: Bloomberg, Threadneedle, EcoWin Reuters November 2014.
Declining inflation has supported bond markets
The decline not only in inflation but also in inflation expectations was one of the main driving themes of 2014. It partly explains why core bond markets have moved so strongly. The huge decline in oil prices, with Brent falling from over US$140 a barrel in 2007 to around US$57 today is responsible for some of the fall in inflation and inflation expectations. A lack of aggregate demand in some regions and the absence of any significant sign of wage inflation, even in economies with reasonable growth, such as the U.S. and UK, have added to these disinflationary pressures. Consequently, the contrast between the fortunes of the providers of labour and the owners of assets are meaningful as property, bond and stock markets have continued to perform strongly.
Investors no longer appear to be pricing in the increasing political risks facing the eurozone
Stubbornly high levels of unemployment remain part of the economic landscape, especially for the younger generation in many parts of Europe. There has been little sign of accelerating economic growth and scant indication of rising wages, even years after the global financial crisis. Perhaps unsurprisingly against this backdrop, there has been a rise in the appeal of more extreme political forces in many countries, most recently observed in the election of Syriza with its anti-austerity rhetoric in Greece.
Yet with the ECB’s bond-buying programme providing support, peripheral European government spreads have compressed further. Where once in 2012, Italian government bonds offered a 7% yield and 500 basis points of spread, yields have now have tumbled to 1.1% and spreads have collapsed to 90 basis points.
This is not to suggest we expect a rerun of the eurozone crisis. It is more that the comparison between increasing political risks and ongoing economic challenges comes at a time of dwindling spreads and ever lower yields.
Very limited scope for further meaningful returns in some government bond markets
Core government bond yields have been declining since the early 1980s in the UK, the U.S. and Germany. As mentioned earlier, the upside potential in some markets is now very limited in the historical context. Following the introduction of quantitative easing by the European Central Bank, government bond yields have reached record lows with a large portion of the European bond market now offering negative yields. It is only in the U.S. and the UK that there is some upside potential. However, in those economies, central banks may consider raising rates in the near future. In contrast, many commodity-exporting countries are likely to see further economic weakness as lower export prices began to impact their economies more broadly, forcing them to maintain lower interest rate policies.
Emerging market bonds are far from homogenous
Varying economic performances, geopolitics and the impact of declining oil and commodity prices are key influences that are causing sharp variations in the performance of emerging market debt. Thus, Ukraine, which has been hit by geopolitical instability and a slowing economy, and Venezuela, which is highly exposed to the falling oil price, fared poorly in the second half of 2014, while Turkey and Indonesia, which have a much more favourable backdrop, performed well. This divergence between winners and losers represents an opportunity for active managers.
Exhibit 2: An environment that favors active managers
Source: Bloomberg, December 2014.
Corporate and high yield bonds
There is concern that corporate bond spreads have tightened to a level such that a crisis severe enough to unwind several years of accumulated gains could occur. Exhibit 3 shows some of the key indicators that might predict an imminent and meaningful correction in credit spreads. As seen by the flags attached to the indicators, we do not believe the end of the credit cycle is imminent. Moreover, the sole red flag that we have identified below (abnormally low volatility) can remain red for extended periods.
Exhibit 3: Key indicators suggest credit cycle has further to run
Left: Source: Threadneedle, November 2014.
Right: Source: Bloomberg, November 2014.
Outlook for 2015
Our central view is that we will experience slow growth. Unless the eurozone slides back into recession, it will be difficult to see returns on government bonds that are meaningfully positive. In investment grade, we would expect spreads to tighten in a slow growth environment. However, in the inflationary recovery scenario, total returns in investment grade would be affected by rising government bond yields due to the longer duration nature of this asset class. We would expect to see high yield and emerging markets debt deliver better returns in the slow growth and inflationary recovery scenarios. However, investors should brace for higher levels of price volatility as monetary policy continues to move in different directions around the globe. These divergent outcomes suggest the benefits of pursuing an active approach in fixed income markets.