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15 Sep 2017

What’s next for the bond markets?


Earlier this year we were rather pessimistic about the outlook for fixed income. Fast-forward a few months and things are looking a little less worrying. Not for the first time, bonds are exceeding expectations – and the big bond yield breakout is nowhere to be seen. 

For the bond bears to be proven right, we need more than good data. We need a significant shift in positioning, some hints inflation (wage-related in particular) is on the mend and less central bank caution. All this is still possible. And the markets are more fragile than they might otherwise appear. So what’s next for yield hunters? 

 

Government bonds

  • A mixed outlook for eurozone government bonds

The ECB is extremely wary of choking off recovery. Stubbornly weak inflation and the encouraging economic catch-up support tighter sovereign spreads over the medium term. That said, we’re wary of further volatility in the wake of ECB pronouncements. 

  • 10-year bond yields – only bunds are near YTD highs

10-year bond yields – only bunds are near YTD highs

  • Playing the periphery

Peripheral spreads have proven remarkably resilient recently. We like Spanish bonds in the main, but tension over the Catalonia referendum is a small cloud on the horizon. Italian government bonds should also provide some carry and possibly even tighten in the near term. 

  • Overweight UK gilts

A gradual deterioration of economic data, and the political uncertainty we’ve seen since June, suggest the Bank of England will continue to side with the doves, despite the less cautious rhetoric of recent days. Only another rise in inflation could lead to an early tightening, which would in turn hamper growth and keep a lid on long-term rates. With this in mind, we still like gilts.

  • Mind your head

The embattled President Trump’s surprise deal with the Democrats kicks the debt ceiling can down the road to December, but it could still result in a shutdown akin to that of 2013. Government bond markets tend to rally at such times as investors seek out safe havens. Don’t be too underweight Treasuries just yet – they are still a safe haven asset, and they are one of the few to come with reasonable carry. 

 

Credit

  • A positive short-term outlook for credit…

We don’t see too much that could derail the credit markets in the short term. While valuations in many segments seem too rich, fundamentals still look good. 

  • ...but stay on your guard

Taking on credit risk seems fine for now, but investors should be prepared to reconsider their positions later this year.  Overbought markets, heavy issuance, rising rate volatility and VIX fluctuations have been, and could again be, reasons for caution. 

  • High yield: an option for optimists 

For optimists, European high yield could still appeal even though the sector is yielding less than its US equivalent. It is also far less exposed to political risk and far less dependent on oil. That said, were government bond yields to move much higher, it could choke off demand for riskier issues. 

 

Emerging markets

  • Emerging debt to continue its rise...

Emerging bonds have performed well so far this year, and we expect further positive returns – albeit not as impressive as they have been.  The crawl towards normal in developed markets should keep flows into higher-yielding assets steady. 

  • ...but credit looks expensive

However, rising rate expectations on both sides of the Atlantic would pressure hard-currency markets, and emerging credit spreads could widen in turn.  What’s more, emerging corporates remain pricy – corporate spreads are more or less in line with sovereign spreads. 

 

Finding the sweet spot

Carefully targeting the best yield opportunities may be more rewarding than banking on all bonds over the coming months. In our view: 

  • Sovereign bonds from three European countries are of particular interest:
  • Spain – where the economy continues to recover
  • France – where sovereigns provide less carry than those on the periphery but look  a better option than bunds for an ultra-safe hold

  • The UK – where growth and inflation data should keep the Bank of England on hold and yields stable at comfortable levels. 

  • Away from Europe, Treasuries look the best option for the more pessimistic investor. A yield of over 2% means they could be well rewarded.
  • For the optimists, we see two decent options: emerging debt and European high yield. We believe the ECB will extend its purchasing programme, and will pay particular attention to the last segment (corporate bonds) it touched, keeping high-yield credit safe. The emerging debt story rests on much-improved domestic creditworthiness. However, inflows have been considerable and its exposure to the Fed is still crucial, so investors should note the downside risk.

Disclaimers:

All opinions/data sourced from Lyxor & SG Cross Asset Research teams. Opinions expressed are as at 23 August 2017.

THIS DOCUMENT IS DIRECTED AT PROFESSIONAL INVESTORS ONLY 

This document is for the exclusive use of investors acting on their own account and categorised either as “Eligible Counterparties” or “Professional Clients” within the meaning of Markets In Financial Instruments Directive 2004/39/EC. 

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Lyxor International Asset Management (Lyxor ETF), société par actions simplifiée having its registered office at Tours Société Générale, 17 cours Valmy, 92800 Puteaux (France), 418 862 215 RCS Nanterre, is authorized and regulated by the Autorité des Marchés Financiers (AMF) under the UCITS Directive and the AIFM Directive (2011/31/EU). Lyxor ETF is represented in the UK by Lyxor Asset Management UK LLP, which is authorised and regulated by the Financial Conduct Authority in the UK under Registration Number 435658. 

Research disclaimer 

This material reflects the views and opinions of the individual authors at this date and in no way the official position or advices of any kind of these authors or of Lyxor International Asset Management and thus does not engage the responsibility of Lyxor International Asset Management nor of any of its officers or employees. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and principal trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, principal trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research.​

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