Safe haven bond yields – and German Bund yields in particular – may remain lower for longer than we previously expected, also supporting credit markets.
On a six to 12 month horizon, however, we still expect bond market weakness to resume, as Eurozone concerns ease, US growth picks up in H2 and investors look for more attractive returns in other asset classes.
Bond markets have been doing well since mid-March, with 10-year US Treasury yields falling from 2.0% to 1.7%. As this followed an almost uninterrupted sell-off since July 2012, it is worth examining whether the recent strength is a reversal of the trend, or largely temporary in nature.
We believe it is the latter, and maintain our underweight on sovereign bonds, even if the sell-off may be slower and yields may remain lower for longer than we had previously expected.
Longer term outlook remains challenging
Central bank intervention and global uncertainties explain the recent bond market rally. They are likely to delay and ease the scope of the bond market sell-off that we have been expecting. Given eurozone concerns, German Bunds may continue to outperform US Treasuries or UK gilts. But we do not think that safe haven bonds can avoid a sell-off altogether in the next six to 12 months, for several reasons:
1. The medium-term global growth outlook
US growth in particular should recover in H2, in our view. Prior to the March payroll number, labour market data was solid and consumption positively surprised, in part because of a wealth effect generated by recovering equity and housing markets. Domestic tailwinds seem strong enough to offset the fiscal tightening effect, and a recovery in H2 should lift Treasury yields.
Growth in Europe may continue to disappoint, but we think that bond markets are most interested in policy: if the Eurozone sticks together and contagion from the Cyprus bailout can be avoided, we think concerns should ease. In fact, Italian and Spanish spreads have started to tighten again and ECB data does not suggest that there have been major outflows out of peripheral bank accounts in recent weeks.
2. Income and volatility
As we have shown in earlier publications, we think that the risk profile of bonds is unattractive: the low yield or income on safe haven bonds can quickly be offset by price corrections when yields start to rise. Although the yield backup was very gradual between July 2012 and March 2013, the 50 basis point move over that period generated a negative total return. Similarly, bond yields may not rise by more than 50 basis points from here by year end, but this would still imply very low total returns.
We thus think that investors will continue to look for alternatives, and migrate into other asset classes.
Positioning
When investors reduce their bond allocations, they typically look to achieve an attractive yield or diversification. We see the following alternatives:
- Search for yield: shorter-dated credit should continue to be supported, as investors prefer credit risk over duration risk. We see most value in senior and non-callable lower tier II bank bonds and short-dated high yield. As investors grow less concerned about contagion from the Cyprus bailout, we think there are some attractive opportunities in the eurozone periphery and euro high yield. We also like emerging market bonds, especially local currency for its carry and its potential for currency appreciation.
- Outside the credit area, we believe high and sustainable dividend strategies continue to make sense in many of our portfolios. Real estate also offers attractive yields in our view, and a degree of inflation protection.
- We think alternative assets can provide diversification. We hold a constructive view on hedge funds, real estate and private equity.
