Given the steep, uninterrupted rally we have witnessed since the end of March, we think it is a good time to reassess how much value is left in fixed income markets, if any.
Our view in risk-free rates generally is that these bonds have done their job, and in the absence of negative rates in the US, Australia and UK there is little more to be had. For credit, however, our view is quite different.
Some of the bonds in credit markets, in particular the higher quality ones, are revisiting their high-water marks in terms of price (and consequently their lowest yields) on a year-to-date basis. It is always tempting for investors to take profit when prices go back to “where they were” before a crash like the one we experienced in March. Some might be particularly tempted this time around given the huge uncertainty that still lies ahead of us, which applies not just to the economic outlook but also to ongoing attempts to restrain the virus and the potential development of a vaccine, areas in which investors have little expertise.
With our credit investor hats on, we would rather look at spreads than absolute yields given the rates environment has changed dramatically. The picture here is quite different. Most investment decisions in financial securities are taken on a relative value basis, not on an absolute basis. In fact, one of the key avenues via which quantitative easing (QE) programmes are intended to work is through the portfolio effect. Put simply, this means that as yields or future returns in risk-free assets decline and confidence returns as a result of very dovish monetary policy, investors are “pushed” into buying riskier assets. In other words, the relative value of those riskier assets becomes more attractive.
Consequently, when we looks at spreads across most assets classes today we are nowhere near the lows. We can see numerous examples of this just at the index level (using ICE indices). US high yield spreads are at 600bp, still wider than Q4 2018. Euro high yield spreads stand at 550bp, again wider than Q4 2018 and similar to other volatile periods such as Q1 2016. EM corporate spreads are at just over 400bp (keep in mind the average rating at the index level is investment grade), quite some way away from Q4 2018 and similar to Q1 2016. The CoCo index paints a similar picture. In recent years, buying spread products with a medium term view at these sorts of levels proved to be a double-digit return investment a few quarters after.
History does not repeat itself exactly, and this time around we have factors that we did not have in previous market downturns. But “this time is different” is also a dangerous statement. In our view, spreads will win the argument. By that we mean that in spite of absolute yields being lower for a given level of spread, which results in optically low yields in credit, spreads have room to continue rallying significantly. Mathematically, this would mean bond prices in credit going well beyond their previous highs, provided government bond yields do not move materially higher (which we think is unlikely).
It would not be a surprise to see more volatility in the coming months given the rally we have just had, and the aforementioned uncertainty related to the virus. But with a medium term view and particularly for those investors seeking income, we believe credit markets are still very attractive.