Global growth remains moderate and fragile and no reduction in monetary stimuli can be expected anytime soon, quite the contrary: many central banks have resumed a more cautious stance, with the Bank of Japan the latest to implement a massive stimulation programme.
Any rise in interest rates should therefore remain limited, making government bonds unattractive in the context of asset allocation.
Opportunities can be found in corporates, however caution is required. Issuers with no or bad credit ratings are appearing, new issue premiums are disappearing and absolute risk premiums are steadily shrinking. Picking the right companies will become increasingly important, and concessions on quality coupled with inadequate risk premiums could take their toll in the future.
Expand your universe
To be able to generate reasonable returns, investors either have to expand their universe to include segments such as the emerging markets, or they have to adopt a more flexible investment approach that allows them to adjust their portfolio dynamically in line with market developments. The ideal solution would be to combine both these approaches.
We believe that in the coming two to three years, emerging markets inflation-linked bonds will become one of the most interesting investment instruments for bond allocators. Inflation-linked emerging market bonds offer high real yields, a steep yield curve with attractive returns for long-dated bonds, and cheap protection against inflation. The asset class also provides investors with exposure to economies with healthy and sustainable debt profiles.
The yield curve of local bonds has steepened again in recent years, and is now offering buyers of long-dated debt an additional return of around 3% compared to bonds with shorter terms to maturity. Against this backdrop, we are investing in the middle and at the long end of the yield curve. Israeli bonds have a lot of potential at the long end, for example. Also, many emerging market bonds offer cheap long-term protection against inflation, making this a favourable entry point. Inflation-linked Turkish bonds are just one example of how cheap these securities are right now, with the consensus estimate for expected inflation not even being priced in.
Asset allocation
In terms of tactical asset allocation, we are focusing on paper from countries such as Chile, Brazil and New Zealand. Chilean bonds are among those offering investors the highest real yields worldwide. Chile’s key interest rate currently stands at 5%, which means its central bank still has sufficient scope to lower interest rates if a weaker global economy impacts the country. Chilean bonds therefore offer a high coupon and the potential for price appreciation if the central bank actually lowers interest rates.
Asian bonds however are not currently attractive given their low returns, and as a result we are holding short positions. South Korea for example is one of the countries that is recovering quickest from the economic weaknesses, reducing the need for persistently low interest rates. We also hold short positions in Swedish bonds.
Real yield
EM linkers continue to materially outperform the other sub-asset classes within the EM local space over one, three and five years. We believe this strong performance can continue, driven by strong fundamentals at a country level, combined with compelling yields and reasonably priced inflation protection. EM linkers have a compelling real yield of 2-2.5% and additionally expected inflation of 4-4.5%, which translates into a 6-7% running yield. This is outstanding in absolute terms, but even more so compared to a 0.3% running yield for five year German-Bunds or 1.6% for corporate bonds.
