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The Federal Reserve balance sheet has increased by $3tn over the last quarter but the Fed potentially needs to monetize a further $1.6tn of US debt in the remainder of the year. We expect that accommodative central bank policy policies and low interest rates are likely to continue for a long time, making it possible for both the government sector and the private sector to sustain their high debt levels. At the time of writing, with real yields for 10-year bonds at around -0.9%, there is little value in treasuries and the risk is for slightly higher yields due to the supply overhang. The balance of risk / reward is simple, with the miserly carry on offer nowhere near enough to compensate investors. We continue to have a preference for strong investment grade rated bonds due to a combination of the Fed becoming a buyer of this asset class, and have been adding BBB rated names on a select basis as this is where the excess spread offers value. We choose to remain cautious on high yield despite the yield on offer in the asset class as the macro picture remains uncertain, and on the back of recent rally in equity markets.
Whilst Brexit uncertainty remains, there is little to concern the gilt market despite comments from Bank of England governor Andrew Bailey who discussed a potential exit strategy (balance sheet reduction occurring before rate hikes) and think it’s far too early for the gilt market to contemplate any unwind of the balance sheet. 10-year Gilt yields are close to their historical lows (with 5-year and 2-year Gilts giving investors negative nominal yields) however, on-going monetary stimulus sentiment will limit the magnitude of any sell-off. Like the US market, it is the lack of a yield that is of most concern for us and as such, we prefer to allocate towards strong investment grade issuers, especially those with a strong cash pile and more global exposure over gilts. The lack of global issuers in the UK high yield market restricts potential investments as we prefer to avoid risk to companies purely exposed to the UK economy.
Throughout the second quarter, we have seen supportive actions and comments for the sovereign market, with peripheral Europe government bonds benefitting the most. ECB governors Rehn and Lane have spoken against explicit yield targets, but we note that a key target of the Pandemic Emergency Purchase Program (PEPP) was to lower the yields on European government bonds (as measured by the GDP-weighted 10 year yields). There may not be an explicit target for individual countries but it is fair to conclude that average yields should remain below pre-PEPP levels for the program to be successful. We do not see value in the core developed government bonds that are on the whole negative yielding and prefer countries on the periphery like Greece and Italy. Investment Grade bonds offer yield in an asset class that is searching desperately for some return, combined with ongoing support from the ECB this makes it a preferred fixed income exposure area for us in EUR. Whilst there is higher yield on offer from high yield issuers, we remain cautious due to the macro environment still in a period of repair following the Covid-19 shock. We also shy away from investing in Additional Tier 1 securities where the potential for loan impairments and low rate environment will affect profitability for banks going forwards.
While developed markets have met the challenge of Covid-19, the focus of the infections appears to have shifted to emerging market countries – particularly Latin America. While yields are attractive, the timing to invest in these regions is not yet given that uncertainty is not aided by potential for resurfacing US/China trade tensions. We want to see the developed countries on a solid footing before going into emerging markets. We also see a dispersion in the universe between emerging market countries s with relatively manageable debt trajectories (i.e. Russia, Mexico) and those less stable debt-to-GDP (i.e Brazil and South Africa) that are offering the highest yields making country selection key.
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If not otherwise indicated, all graphs are sourced from Dolfin research, July 2020.
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