Bonds Commentary

Lower Returns, Higher Volatility Likely.

January 2020

While 2019’s returns are hardly indicative of such a backdrop, it is a challenging time to be an investor in fixed income; yields on global sovereign bonds are either negative or below expected inflation, while credit spreads are tight, and ‘relative value’ is the only value to be found. The Bloomberg Barclays Aggregate Bond Index (Agg) turned out an 8.7 percent return in ’19, while the Blomberg Barclays investment grade and high yield corporate bond indices rose 14.5 and 14.3 percent, respectively –a banner year for bond investors! As we’ve noted before, outsized returns for bonds pull forward and decrease future expected returns, while volatility expectations likely must be moved in the opposite direction, setting up a less appealing risk-adjusted return environment as we enter 2020.

The recent air strike in Iraq highlights the continued importance of fixed income diversification in the current environment as those out over their skis reaching for yield via corporate or emerging market bonds have experienced near-term volatility, while investors in longer-term U.S. Treasuries fared better as capital inflows pulled interest rates lower/prices higher as the safety trade took off. Geopolitical flare-ups are increasingly common, with far-reaching and often unforeseen implications for global fixed income markets, as countries thought to be relatively insulated from the fray experience capital inflows or outflows, along with significant currency fluctuations, amid ‘risk on’ and ‘risk off’ portfolio shifts.

Japan comes to mind as just one example. The Japanese economy, in theory, should be largely immune from a U.S./Iran dust-up. However, in the aftermath of the air strike, investors shifted to a ‘risk off’ stance, leading to a flight to safety and a sharp move higher in the Japanese yen and a rally in Japanese Government Bonds (JGBs). Significant yen appreciation is worrisome, as Japan is an export-heavy economy and as the currency appreciates, Japanese goods become more expensive for foreign buyers at the margin. This may prove to be an inconsequential event should fears prove short-lived, but persistent yen strength would have broader implications on global economic growth expectations and dash the hopes of those speculating that manufacturing activity bottomed in the fourth quarter of last year.

The merits of owning long-term U.S. Treasury bonds as part of an investors’ fixed income allocation were on full display early in January. Exposure to longer-term U.S. Treasuries makes sense as part of a diversified portfolio, primarily as an equity hedge given low yields and high durations, but it won’t take much of an inflationary shock or upward surprise on the economic growth front over the coming quarters to generate a negative total return, on paper anyway. Appropriately sizing exposure is crucial.

The consensus among Wall Street strategists entering the new year is that U.S. Treasury yields are anchored and are unlikely move very far from current levels over the course of 2020 with the FOMC on the sidelines and inflation under wraps. While the ‘consensus’ opinion may play out, that doesn’t rule out significant intra-year volatility in interest rates. With rate stagnation being a widely held view, upward revisions to expectations for inflation and/or economic growth over the coming quarters could lead to significant portfolio repositioning and volatility in rates. Relative value remains in asset-backed securities and emerging market debt, but we’re less positive on corporate bonds, broadly speaking, as we enter the new year, and will be looking for opportunities to selectively lower exposure.

Source: Bloomberg, Factset


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