Bond back to Core: where is the value in the current economic cycle?
Thursday 03 October 2019
News, Fixed income
“Slowdown in global growth with subdued inflation and dovish Central Banks (CB) committed to avoid further economic deceleration are trends that should remain favourable for bond investors.” begins Eric Brard, Head of Fixed Income at Amundi. “On one side, investors should limit the upside in core bond yields and, on the other, support the credit market, despite the strong spread compression in this first part of the year. An increasingly selective approach will be crucial.”
Fixed Income investing is back
A recent business intelligence analysis1 highlights that April 2019 was a turning point in bonds’ investments in both the USA and Europe. Total flows allow offsetting Q4 2018 in April and the market can expect positive flows afterwards. Passive funds are growing fast. Institutional investors seek again core strategies.
Other dominant forces within the fixed income environment are the increased role of politics, the still present short-term downside risks on the economy, the high level of debt globally and, moving towards the long-term, rising acknowledgment of climate and societal-related risks.
Against this backdrop, rethinking fixed income investments as a core part of investors’ portfolio is crucial both to deliver attractive risk / adjusted returns and to seek protection and effective diversification in the phases of market turmoil.
Amundi identifies three recurring themes for investors:
- The search for yield further emphasized by the rally in core bonds
- The need to embrace a flexible and diversified approach in a late phase of cycle when sudden changes in market sentiment are more likely
- The emergence of ESG and climate change as key topics in portfolio construction
Considering the come back to potential GDP growth for most of developed economies, difficulties to achieve the inflation target for Central Banks and the high level of sovereign debts, which justifies also the vigilance of CBs, the current market equation is simple. Low interest rate + tight risk premia = high valuation. Clearly, active management, credit research and right solutions, particularly in terms of format positioning and access to the markets, are keys to cope with liquidity management and risk issues.
Looking for an oasis of yield
Traditionally, to increase their yield, investors have ended up taking additional liquidity risk (private debt, structured credit), duration risk (classic way to extend exposure at the far end of the curve with sovereign long-dated bonds) or default risk (high-yield). The market still presents some opportunities, either in sovereign or credit space. Indeed, within the defined low rates scenario unfolding on both sides of the Atlantic, the sub-segment becomes a key area to look at if properly screened.
Credit investment grade remains an attractive asset class for carry reasons, especially in Europe. Quality of corporate balance sheets were default rate is a lagging indicator, is a reality. Easy access to funding corporates is still true. These securities provide historical premiums over senior debt.
Government bond yields across the world are falling, as there is strong demand for safe assets and scarce supply. Investors in search for safe assets are looking at core bonds and high quality bonds as a diversifier of risk assets, during phases of market turmoil. As liquid assets, they will likely remain in strong demand.
Fixed Income are not only an alpha generator but also a potential shock absorber when market conditions are tougher on riskier assets. This year, the market story will thus be a carry and flexibility story.
Source: Bloomberg and Amundi, as of 13 June 2019
 Source: Bloomberg. Data as of 25 June 2019
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Asset Class Return Forecasts - Q4 - 2019
Our medium-term baseline scenario is that of a late business cycle slowdown supported by the dovish U-turn of central banks. We expect economic growth to move below potential for most developed economies in 2020, a trend that will be further exacerbated in 2021 by a deteriorating cyclical environment and still anaemic global trade. Nevertheless, growth is expected to stay in positive territory.
Trade war escalation and impact on world trade and economic growth
Trade tensions re-escalated during the summer. Starting on 1 September, the US Administration introduced new tariffs and China retaliated simultaneously. More tariffs are likely from the US side, including an increase in tariffs already in place from 25% to 30% and new tariffs on the last tranche of imported goods from China. Concerning extra-tariffs measures, in August the temporary licences granted to US companies to operate with Huawei were extended upon their expiration but, so far, with no additional structural guidance.
Central banks have confirmed the shift to a much more accommodative stance
In their September meetings, both the ECB and Fed confirmed their easing mode. The ECB delivered a full monetary policy package (pre-announced in previous months), combining conventional and unconventional tools, together with the introduction of new measures aimed at reducing the sideeffects of negative rates.