CPD: Ten most important charts for fixed income investors

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Since the end of the Global Financial Crisis (GFC) there has been eight years of ‘sunny skies’ – however, with interest rates and inflation moving upward, Brad Boyd CFA, Portfolio Manager with fixed income experts Payden& Rygel (Payden), sees some potential for ‘rainy days’ ahead. In this article, Grant Samuel Funds Management shares a series of charts and insights recently delivered by Brad in his presentations across Australia.

Bonds are important for a diversified portfolio. They’re generally considered a defensive investment, the stable, safe component when compared with the more volatile equities and other growth investments. However, it’s important to be aware of changes in the investment environment, some of which herald the prospect of more challenging times for fixed income investments. Despite the ‘defensive’ nature of fixed income securities, they too can experience volatility.

Since the GFC, yields in both government and corporate bonds have fallen globally. Because of the inverse relationship between yield and price, this has meant the price of bonds has risen. Now however, yields are starting to rise – and, because of this inverse relationship, prices of fixed income securities are falling. While this may herald a more challenging time for bond investors, there are good reasons to retain an exposure to fixed income investments in a diversified portfolio.

Global growth

Despite headlines warning of global recession and other doomsday economic scenarios, the fact is, as illustrated in chart one, only four regions have a material impact on global GDP – China, India, the United States and the Euro area.

 

 

The global growth story differs substantially from repeated media themes that economic expansion is getting long in the tooth and a pull back, or recession is due. While historically recessions have generally occurred every 8-10 years, economies don’t die of old age – Australia – which is experiencing 20+ years of economic expansion – is the perfect illustration. Global growth should be about longer fundamental trends, not time.

Despite headlines about Brexit setting the UK off course, Britain is a small component of what’s happening globally – according to Payden, analysis of the numbers should be about the collective, not the individual.

When you look at the number of countries in recession, as illustrated in chart two, only six countries will have negative growth in 2018 – and they represent just 0.4% of world output.

 

 

Current employment data suggests that economies are resilient, and global growth should continue.

The consumer

Since 2000, there have been numerous changes in the consumer market, many of which are based on demographics. For example, as illustrated in chart three, the top three growth areas are focused on medical and health expenditure, and most relevant to the baby boomer generation. Housing, eating out and education are creeping up, expenditure that tends to be more related to millennials.

Consumption has implications for both fixed income and equities. At Payden, the team has started overweighting securities issued by the medical/health sector and underweighting shrinking sectors such as autos. Whether equity or fixed income, these longer-term consumer trends really matter.

 

 

The yield curve

What can disrupt the growth trajectory? The yield curve is one of the barometers for analysing growth. Historically, the relationship between the yields of 3 and 10-year US Governments bonds has been a good signal for potential recession.

The logic to this is as follows: banks work on the premise of ‘borrow short/lend long’. A ‘normal’ scenario is one where there is more yield potential further out; conversely, when the situation is inverted, there is little point in investing where there is no prospect for profitability. As well as being historically true, this logic follows history.

Despite the present rhetoric in some quarters, as shown in chart four, the yield curve does not currently indicate recessionary influences in the US. Where there is simply a flattening of the curve, as is the current situation, it’s not necessarily disruptive. It does however, bear watching to see if there’s any potential disruption to growth.

Once the line – which represents the 10-year US Government bond minus the 3-year US Government bond – inverts, it tends to precede a recession – there generally isn’t a change until the yield curve inverts.

Recessions are represented by the vertical pale grey line in chart four, and its width indicates the duration of the downturn. This is one of many measures scrutinised by Payden’s team.

 

 

Inflation

 

Volatility in markets earlier this year was related to fears that US inflation was rising faster than expected. Interestingly, US core inflation excludes some of the most volatile components, such as food and energy – both of which are important price measures for most consumers.

As a result, the US Federal Reserve (the Fed) developed the Underlying Inflation Gauge (UIG) to help forecast core CPI – the UIG has 400 inputs, including energy and food. The UIG is used by the Fed to forecast inflation 15 months out.

While the Fed has been using the UIG for some time, it has only recently been released for public use. As shown in chart five, the Fed’s model suggests that inflation will continue to rise, which will have implications for future interest rates.

Payden’s economics team believes US inflation is likely to increase to 2.5%. Related to this, it also believes the Fed will increase interest rates four times over the next 12 months, moving from 1.75% to 2.75% this time next year, and probably head towards 3-3.25% as its ‘neutral’ target rate.

This general trend in both inflation and rates will be global, albeit with different timing.

Funding rates

 

While funding rates have risen, it’s not surprising given the Fed has increased rates. However, the benchmark London Interbank Offer Rate (Libor) rates are nowhere near where they were during the GFC. Payden believes this is normalisation from the extreme lows of the past seven-to-eight years.

 

 

This normalisation is occurring, in part, because there is pressure on the front end from the US budget deficit. In the past quarter, the US government has issued US$211 billion in government bills. Flooding more supply into the market – which, as shown in chart seven last happened during the GFC – is putting pressure on the front end of the yield curve.

 

 

Another factor impacting the short end of the yield curve is the repatriation of cash from offshore earnings by numerous Fortune 500 companies; the changes to the US tax regime late last year incentivised companies to repatriate funds.

As a result, funding rates came under pressure from front end bond liquidations; rather than these companies buying short-term bonds or other money market instruments and cash securities, most sold them down and used the cash to pay special dividends and/or buyback shares.

In fact, corporate holdings of marketable fixed income securities decreased by US$50b in the first quarter of 2018.

Payden believes this trend will continue…more cash will be repatriated, and more stock will be bought back. Although this will continue to put pressure on the front end of yield curve, Payden believes this is healthy because it returns the system to more normalised levels.

Corporate credit remains compelling

 

Just a few years ago, 1-3-year corporate bonds were yielding barely more than 1%. Companies such as Disney and Apple issued 3-year bonds in 2012 and 2013 that had coupons of just 0.45% as investors devoured new bonds.

However, front-end corporate yields have risen 77 basis points (bps) already in 2018; this has 1-3-year interest rates moving 66bps higher, coupled with widening in front-end corporates driven by cash repatriation. According to Payden, high quality front-end corporate yields haven’t looked this attractive in a long time.

Both the credit curve and rates curve are quite flat, making the front end an attractive place to invest. While traditional corporate cash buyers may be sitting on the sidelines for now, Payden is seeing new buyers step into this market.

Emerging markets

 

Developed market (DM) bond yields have not compensated for inflation in recent years, while inflation-adjusted emerging market (EM) bond yields are positive – or, in other words, investors are being compensated to take on the additional risk.

While DM inflation is starting to climb, EM inflation is running at historical lows and, although most EM countries have eased monetary policy, they have not eased as aggressively as their DM peers. The differential between DM and EM yield is a longer-term trend, one which has been years in the making; this yield differential is a key measure used by Payden when analysing EM debt.

Going forward, yields will continue to rise, and the price of fixed income securities will fall. This is not, according to Payden’s Brad Boyd, the optimum time invest in a fixed income fund that is anchored to a bond index.

Global fixed income indices measure two exposures: country exposure, generally weighted towards those countries that have issued the most debt, and security exposure, also weighted toward those that have issued the most debt. If the index has a longer duration profile, a fund anchored to that index generally reflects that duration too.

Conversely, an unconstrained investment strategy is not beholden to a benchmark and is designed to better to navigate the complexities of the evolving fixed income landscape and changing economic environment and has the best opportunity to deliver positive returns in such an environment.

 

 

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Payden & Rygel and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Payden & Rygel, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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