(By Steven Oh, CFA – Pinebridge Investments for HedgeNordic) – Over the past decade, investors in U.S. debt securities have had a good run, boosted in recent years by the Federal Reserve’s gradual interest rate tightening. While the global economic climate should remain favorable for fixed income securities over the foreseeable future, we see the seeds of significant macro shifts over the longer term.
Specifically, we are watching four trends:
- Global rate normalization. Rate normalization in the U.S. has been a major theme across fixed income markets during the past several years. Higher rates now may be ahead globally, as the European Central Bank (ECB) as well as the Bank of Japan (BOJ) appear poised to begin tightening sometime in 2019 or 2020.
- A trail off in U.S. monetary tightening: The interest rate decoupling that has dominated global markets since the Federal Reserve began raising rates may now go in the opposite direction, as the U.S. is likely to end its tightening cycle both in terms of rate increases and balance sheet contraction, and potentially transition to a loosening cycle.
- Less favorable U.S. technicals: With its rapidly expanding budget deficit set to surpass $1 trillion by 2020, the U.S. will need to increase debt issuance substantially, even as Treasury yields become less competitive. The potential oversupply could meaningfully pressure valuations.
- Lower returns, greater volatility, wider dispersions: Today’s generally pricier credit valuations and continued signs of a late-stage global economic expansion are setting the stage for lower long-term return expectations and potentially elevated volatility. As the greater dispersions now seen in emerging markets move into developed markets, opportunities are growing for security selection.
Given the possibility of these trends coming to pass, we believe that investors should review their portfolio and consider the following steps to position assets for this emerging transition period in fixed income.
Paring back riskier credits
Despite an investment climate that has remained favorable for so long, we must not forget that credit cycles have not died. Instead, they have become elongated, with the European sovereign debt crisis and the recent commodity collapse as two recent examples of relatively short-lived selloffs from which the market bounced back reasonably quickly. But long-term corrective declines are inevitable, and when pre-decline excesses are too great, there is a thinner valuation cushion to absorb a downturn. Today, the probability appears to be rising for a credit downturn that will last beyond a quick “buying opportunity” market dip. This implies that investors may be rewarded for paring back the riskier credits that generally have outperformed over the past few years, and focus on fundamentals to determine the strongest risk-adjusted return potential.
Rethinking U.S. treasury allocations
Over the past few years, the U.S. bond market has offered a global yield advantage on a foreign-exchange-adjusted basis that has continued to attract investors and support prices despite the Fed’s monetary policy tightening cycle. But as the ECB and BOJ begin to increase rates and normalize monetary policy, European and Japanese yields will likely become more appealing to local investors relative to US debt. This should lower global demand at the same time that the supply of U.S. Treasuries is likely to increase as government debt rises to its highest levels ever.
This technical pressure could have major implications for U.S. Treasuries’ traditional role as a safe haven, causing foreign holders of Treasuries to shift back to domestic assets. For example, we believe a yield of 0.5% on 10-year Japanese government bonds will be a level at which a significant portion of bond demand may be enticed to move back home. The same scenarios could play out across other foreign investor segments as well.
While US Treasuries should continue to serve as insurance against extreme market shocks, the supply-demand imbalance is apt to result in greater volatility than in the recent past. As a result, we suggest caution. We continue to prefer U.S. Treasuries over other developed-market sovereign bonds in cases where a move to monetary policy normalization would disadvantage a nation relative to the U.S., but we do advocate for increasing US Treasury allocations at this time.
Taking a closer look at emerging markets
With greater capacity for expansion, fairly tame inflation, and relatively attractive valuations after a recent selloff, emerging market debt appears to be headed for a long positive run despite growing dispersions across regions and segments. For example, overall volatility has increased for the broad J.P. Morgan Emerging Market Bond Index year to date, but yields for sovereign debt in Argentina and Turkey, for example, have spiked even more. Since spillover from elevated U.S. dollar volatility and tariff uncertainties also are causes for concern, investors should be selective in individual security exposures despite general bullishness.
While we believe markets will remain largely favorable through 2020, negative forces can emerge quickly and unexpectedly. As a result, being slightly more defensive in portfolio positioning makes sense. That translates into a modest dialing back of risk in each segment, reducing high beta exposures and incrementally lowering duration risk profiles, particularly in developed markets outside the U.S., as well as focusing on higher quality credits within segments.
- In investment grade credits this can involve trimming BBB allocations and more cyclical sectors, as well as moderately increasing collateralized loan obligation (CLO) holdings. Historically, CLO tranches rated A or higher have suffered no loss of principal when held to maturity.
- In leveraged finance we favor higher quality defensive secured loans over high yield bonds, where investors should consider decreasing CCC-rated allocations. In Europe, floating-rate loans may be better than assets prone to interest rate risk, and additional caution is urged for Southern European credit exposures.
- Within emerging markets, investment-grade securities may make more sense than high yield debt — although tactical opportunities exist among strong businesses caught in the downdraft of sovereign volatility in countries such as Turkey, Argentina, and Brazil. On the sovereign side, volatility also may present opportunities to invest at attractive valuations during selloffs. Using dynamically managed multisector strategies that have the agility and flexibility to seize opportunities and control volatility may be a good choice for some investors at this time.
Given what the future is likely to hold, we believe it does not pay to dive into the riskiest parts of the market at this time. In fact, it now appears prudent to begin marginally dialing down risk across and within asset classes. This slightly defensive tilt should help investors lock in past credit gains and better navigate anticipated cycle changes of expected lower returns, greater volatility, and a return to global rate normalization.
This article was written by Steven Oh, CFA – Pinebridge Investments
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