With treasury yields moving aggressively higher this year, anyone reading or listening to the financial press will have become very accustomed to headlines highlighting the negative performance of “Bonds”. In addition, with the term ‘bonds’ being used interchangeably with ‘fixed income’ and ‘credit’, you could be forgiven for thinking that all parts of fixed income were struggling – an impression that practitioners of the equity markets are also happy to sustain.
The actual performance of fixed income is a bit more nuanced. Government bond markets have certainly struggled, with the BAML ICE Treasury index is down 4% YTD, in sterling terms. Meanwhile, the improving sentiment for the UK has hit UK sovereigns hard, causing the Gilt index to fall by 6.6% YTD, bearing in mind the index’s long-dated nature, with a maturity of over 16yrs; double the length of the dollar index.
High quality, investment grade rated bonds, which trade on a spread over government curves, have also unsurprisingly struggled. In particular, longer dated bonds, and the dollar and sterling IG indices, both with durations of approximately eight years, are down 3.6% and 3.9% respectively, again in sterling terms. However, other government curves, have performed better, with the European government curve, although not immune to the Treasury move, better anchored by negative European deposit rates. In turn, the Euro IG index has fared comparatively better, falling by just 30 basis points this year.
Other parts of the fixed income universe, however, have performed much better, especially higher yielding areas where bonds are often shorter dated, have ample spread to compensate for the duration move, and are in sectors that are pro-cyclical and buoyed by the improving sentiment, rather than hampered by it. Looking at High Yield, the sterling, dollar and euro indices, have returned 2%, 1.6% and 2.2% respectively year to date, again in sterling terms. High yield corporates are less correlated to government bond moves, as they don’t typically trade at a specific spread to sovereigns. That said, the dollar index was somewhat impacted by the Treasury curve, given it the lowest return. On the other hand, European corporates were the top performers, even as European vaccine rollouts lagged both those in the US and UK, causing some lockdown extensions, and probably hampering growth this year. Investors have looked past this delay, focusing on the expectation that the end is in sight and on the ECB support packages. At the same time, the comparatively more anchored government bond curves and subdued inflation expectations in the EZ relative to the US provide additional supports for European credit.
Away from high yield sectors, subordinated bank bonds have continued their strong performance from last year, and the COCO index is up 2.4% year to date, as sceptical investors, who shunned the sector after the global financial crisis, are re-evaluating banks following their strong resilience in the face of the Covid pandemic lockdowns. With an attractive spread, and a diversified range of banks, with strong capital ratios and balance sheets, it’s not a big surprise to us that the COCO index is once again producing attractive returns.
The outperformance of credit assets, in particular of those in the lower ratings bands, is not a surprise at this stage in the cycle. The source of risk for fixed income portfolios shifted from credit risk at the very end of the cycle last year to interest rate risk as the economic recovery takes hold. This scenario is consistent with default rates decreasing going forward, which supports spread compression in riskier credit. Spreads in this sector are still able to offset the move higher in underlying government bond curves as performance has shown year to date.
Investors should look carefully at the detail when the press talks about “bonds”, as it is a somewhat generic term that covers many varieties with differing characteristics!