Learning to Love Low Yields

Despite yields plunging following the Fed’s coronavirus-motivated rate cut, we believe opportunities still exist in bond markets.

Despite the widespread belief that the US Federal Reserve’s (Fed) coronavirus-motivated interest-rate cut is pushing on a string, we expect other central banks to follow the Fed. This means government bond yields are likely to fall further and the stock of negative-yielding debt is set to balloon. We believe fixed-income investors will need to acclimatize to a low or negative-yield environment for some time to come.

Coronavirus crisis aside, the other powerful forces exerting downward pressure on yields merit examination. On the one hand, ageing populations – particularly baby boomers in developed economies – are now not only spending less but also de-risking their portfolios and moving away from equities in favor of bonds. On the other, the internet, connectivity and the power of online shopping are creating better opportunities for consumer price discovery than ever before. Taken together these two trends – ageing and innovation in technology – are inherently deflationary. Coupled with easy monetary policy and quantitative easing – whereby central banks provide an ever-present, ever-willing market for bonds – the overall effect has been for yields to practically diminish to zero and into negative territory in many cases.

Unexpected Consequences

The consequences of this low-yield backdrop are both positive and negative. On the one hand, countries with reserve or quasi-reserve currencies are able to borrow for virtually nothing. In the UK, for example, the government’s decision to go ahead with building a high-speed rail network is boosted by its ability to issue debt at virtually zero cost. Japan has rolled over debt for decades at little cost and without any real consequences. The US is running historically high deficits, yet yields are at historic lows. Even Greece, hardly a watchword for fiscal responsibility, now has bonds trading at barely above negative yields.

The Flipside

But cheap money has its drawbacks. It enables less-than-healthy entities to survive just by virtue of being able to roll over debt at practically no cost. In the corporate world, defaults become a rarity and the traditional risk/reward mechanism begins to break down given the lack of penalties for fiscal profligacy. In consequence, active investment managers seeking price discovery find it ever more of a challenge to distinguish good companies from bad. In credit markets it means there’s a whole raft of zombie companies out there essentially on life support. Part of our job as investors is to understand the cost of risk – but now that’s more of a challenge than ever.

Current Positioning

This doesn’t mean, however, that opportunities for fixed-income managers to make money are entirely absent. The key thing is to find parts of the bond market where you are being paid more than inflation. That is why we think it’s so important for investors to be prepared to take an unconstrained approach.

In our global dynamic strategies, we are avoiding sovereigns in Europe and the UK – where yields remain in negative territory – in favor of an allocation to the US, Australia and New Zealand.

In credit, higher returns are on offer from some of the more stable telecommunications and cable companies in the high-yield space. However, quality is important. We are avoiding triple C-rated credit and we won’t invest in companies we think are overleveraged or have overstretched themselves. We are also avoiding commodities and the retail sector.

In emerging markets, sovereign allocation is to local-currency bonds in countries with the freedom to cut interest rates – or in hard currency in short-dated bonds in countries with cash reserves and the ability to refinance themselves should the US increase interest rates.

The coronavirus has altered our expectations for 2020 from a trundling year of steady yields, adequate risk and a reasonable return to one where risks are now more prevalent. Central banks, including the Federal Reserve, have already cut rates in response to the virus, and investors are now pricing in serious economic consequences with further monetary easing to come.

Authors

Jon Day

Portfolio manager, Fixed Income team