“Game Over” for Treasury Bonds

Althea Spinozzi
Head of Fixed Income Strategy

Summary:  This year will prove challenging for bondholders as the negative real policy rate adopted by central banks has reduced downside tail risk on one side but squashed risk premia on the other - Q1 outlook 2021

Bonds performed exceptionally well in 2020 as central banks and governments worldwide provided robust policy support to underpin households and businesses, amid an unprecedented income shock. This year will prove challenging for bondholders as the negative real policy rate adopted by central banks has reduced downside tail risk on one side but squashed risk premia on the other.

In the first quarter of the year, investors will need to get ready for two possible scenarios ahead. Either the market will continue to need new stimulus to deal with a resurgence of Covid-19 cases, or a strong recovery will force authorities to reduce their economic stimulus gradually. While in the first scenario we will most likely see a copy and paste of what we saw last year, in the case of a robust recovery the government will gradually withdraw stimulus, leaving weaker companies at the mercy of rising inflation and higher interest rates. Unfortunately, in both cases, fatigue could push policymakers to commit a mistake for which the bond market could pay handsomely. 

The only way to hedge against a policy mistake and rising inflation will be to seek coupon income while reducing exposure to near-zero yielding debt. As real rates will continue to fall, duration and low nominal yields will prove toxic, while higher-yielding securities such as junk and emerging market bonds can provide an adequate buffer as the economy finds a new equilibrium; cherry-picking will be vital. Similarly, inflation-protected securities will provide an important hedge against rising inflation despite their negative yield. Promising opportunities in the corporate space lie within the environmental, social and governance (ESG) and energy sectors, due to the pandemic-fuelled shift of focus towards sustainability and rising inequality, and a path to recovery will foster energy demand.

US Treasury Bonds: a ticking bomb

In light of the Average Inflation Targeting (AIT) approach implemented last year by the Federal Reserve, the probability of a policy mistake is exceptionally high. Within this framework, the Fed is committed to limit the rise in nominal yields even if inflation rises above its target. This means that while the Fed's monetary policies will pin down short-term yields, market sentiment will affect the longer part of the yield curve. Long-term nominal yields could rise fast, precisely as we have seen at the beginning of the year as Democrats took control of the Senate. As the market braces for a bear steepener yield curve, bond value will fall sharply and returns will mostly come from coupon income. Unfortunately, Treasuries are still offering the lowest yield in history, providing no buffer against rising yields and exposing investors to considerable losses. 

Since the mid-70s Treasuries have closed the year with negative returns only four times. In 2021 we could see them closing the year with a negative return for the fifth time in more than forty years. The longer the maturity, the higher the loss investors are facing. For example, if 10-year Treasury yields close the year 50 basis points higher, bondholders would incur to a loss of approximately 4.7%. If 30-year Treasury yields also move up by 50bps, the loss bondholders would suffer will be more than 10%. We discourage investors from taking long duration in this environment, marking the end of an era for ETFs with high duration, such as iShares USD Treasury Bond 20+yr UCITS ETF (TLT).

Amid falling real rates, we continue to favour Treasury-Inflation Protected Securities (TIPS). It is crucial to know that it’s not necessary to see an increase in the Consumer Price Index (CPI) for TIPS to rise in value. Indeed, it is just enough that inflation expectations, such as the Breakeven rate and the 5y5y inflation swap forward rate, rise to make TIPS a compelling investment, despite the negative yield they are offering at the moment. Exchange-traded funds that can give exposure to TIPS are iShares Barclays TIPS Bond Fund (TIP) and PIMCO Broad U.S. TIPS Index Fund (TIPZ), as well as the iShares USD TIPS UCITS ETF (TPSA) for euro investors.

Long duration: the only game in town for European bondholders

Austerity is a word that was erased from the vocabulary last year as governments across Europe issued more debt in the wake of the Covid-19 pandemic. By the third quarter of 2020 Germany had increased its debt by 14% from the beginning of the year, while France had increased debt by 12.4%. As tighter lockdown measures are imposed in the first quarter of this year, we can expect more stimulus from European policymakers, making European sovereigns a compelling buy opportunity. Furthermore, a combination of ECB policies and the Recovery and Resilience Fund (RRF) will support the economy as government stimulus begins to fade in the second half of the year. Not only that, but the RRF could also be seen as contributing to the creation of a more robust and united economic bloc, which could boost sentiment in the periphery. 

Investors should not be discouraged by historic low European yields, as capital appreciation will continue to be the only game in town for all of 2021. In particular, sovereign yields of the periphery will continue to narrow relative to those of Germany.

Italian BTPs are poised to benefit the most from monetary and fiscal policies as they trade rich compared to their peers. The spread between 10-year BTPs and the Bund will most likely fall below 100bps to tighten as much as 90 bps. It will result in 10-year BTPs (IT0005422891) yields falling to 0.4%, representing an upside of around 1.5% for bondholders. Unlike US Treasuries, long duration will play in favour of bondholders in the European space. Thirty-year BTPs (IT0005398406) could go up as much as 10% as the spread between 30-year BTP and the Bund falls below 120 basis points. 

Duration will favour government bonds in Europe as a whole, benefitting ETFs such as the Xtrackers II Eurozone Government Bond 25+ UCITS ETF (DBXG) and the Xtrackers II Eurozone Government Bond 15-30yr UCITS ETF (DBXF). 

Percentage gain/loss according to a given movement in yield

ISINDurationConvexity+/-10 bps+/-50 bps+/-80 bps
10-year TreasuriesUS91282CAV379.390.9540.94%4.70%7.52%
30-year TreasuriesUS912810SS8723.36.4362.33%11.66%18.66%
10-year BundDE000110253110.141.1321.01%5.07%8.12%
30-year BundDE000110248129.639.0772.96%14.83%23.73%
10-year BTPsIT00054228919.711.070.97%4.86%7.77%
30-year BTPsIT000539840621.795.9142.18%10.90%17.45%

Source: Bloomberg and Saxo Group.

The beginning of a new era for the United Kingdom sees upside for inflation-linked government bonds

Although Gilts in 2020 offered protection against the volatility provoked by the Covid-19 crisis and Brexit noises, this year they will suffer from an identity crisis. On one side there are expectations of an economic rebound due to the rollout of a vaccine and a Brexit deal; on the other we have tighter lockdown measures imposed in the wake of a third Covid-19 wave, and the uncertainty of how the British economy will fare without the European bloc. As a consequence, sentiment in Gilts will remain mixed before finding a proper direction. A neutral stance will be the most appropriate strategy for the first quarter of the year. At the same time, it is important to monitor how the economic backdrop develops. A large part of the market expects a rate cut from the Bank of England that will push nominal yields lower, but if inflationary pressure arises, it will be unlikely that the BOE will embark on this journey, leaving yields free to rise. 

The indisputable trend that we will witness in the sterling bond space will be a steady fall of real yield. Higher nominal yields will not match higher inflation expectations, as policymakers will try to keep borrowing costs lower for longer to kickstart growth. In this context, it is crucial to reduce weight on nominals and enter inflation-linked bonds, or ETFs which track inflation such as the Lyxor ETF iBoxx U.K. Gilt Inflation Linked (GILI).

Another way to reduce the risk of falling real yields is to buy higher-yielding security. However, sterling spreads have tightened below pre-pandemic levels, meaning that credits are more expensive than a year ago despite carrying higher default risk. Rather than buying into a single name, investors could consider entering in high-yield corporate ETFs such as the iShares Global High Yield Corp Bond (GHYS), in an effort to ensure diversification.

Green bonds will continue their rise

Governments and corporates are expected to issue $500bn in green bonds this year, which is more than double the amount issued in 2020. Governments will be inclined to increase investments in this sector, as studies have found that green infrastructure investment creates more jobs than other traditional investments. 

Green bonds represent the perfect opportunity for investors to diversify their investments into a new sector about to flourish. It is particularly true for euro-denominated green bonds, as interest rates will remain low for longer. Regarding US dollar-denominated green bonds, investors should cherry-pick and beware of duration, as already explained above. At the moment, corporate green bonds offer a pickup of around 80 basis points over their benchmark both in the United States and Europe, which unfortunately doesn't give enough protection against rising yields in the US.

Sovereign Bond ETFs 

5Y %

U.S. Treasuries ETFs
iShares USD Treasury Bond 20+yr UCITS ETFTLTUSDUnderweightYes18.2%38.5%
iShares USD Treasury Bond 20+yr UCITS ETFDTLEEURUnderweightNo15.2%18.8%
iShares Barclays 10-20 Year Treasury Bond FundTLHUSDUnderweightYes13.8%26.4%
iShares Euro Government Bond 10-15yr UCITS ETFIEGZEURUnderweightNo6.7%24.6%
iShares USD Treasury Bond 7-10yr  ETF IEFUSDUnderweightYes10.0%21.2%
iShares USD Treasury Bond 7-10yr  UCITS ETF IBCMEURUnderweightYes4.0%15.7%
iShares USD Treasury Bond 1-3yr UCITS ETFSHYUSDNeutralYes3.0%8.2%
iShares USD Treasury Bond 1-3yr UCITS ETFIUSUEURNeutralNo-6.0%-6.3%
iShares Barclays TIPS Bond FundTIPUSDOverweightYes10.4%20.6%
iShares USD TIPS UCITS ETFTPSAEUROverweightNo1.2%4.6%
PIMCO 15+ Year US TIPS IndexLTPZUSDOverweightYes23.5%43.2%
PIMCO Broad U.S. TIPS Index FundTIPZUSDOverweightYes10.7%21.0%

European Government Bonds ETFs
Xtrackers II Eurozone Government Bond UCITS ETFDBXNEUROverweightYes4.6%14.9%
Xtrackers II Eurozone Government Bond 25+ UCITS ETFDBXGEUROverweightYes16.2%55.2%
Xtrackers II Eurozone Government Bond 15-30yr UCITS ETFDBXFEUROverweightYes11.4%38.9%
Xtrackers II Eurozone Government Bond 7-10yr UCITS ETFDBXBEUROverweightYes4.2%16.0%
Xtrackers II Eurozone Government Bond 5-7yr UCITS ETFDBXREURNeutralYes2.8%8.9%
Xtrackers II Eurozone Government Bond 3-5 y UCIT ETFDBXQEURNeutralYes1.5%4.3%
Xtrackers II Eurozone Government Bond 1-3 y UCIT ETFDBXPEURNeutralYes0.1%-0.6%
Xtrackers II Eurozone Government Bond Inflation-Linked Bond ETFDBXKEURNeutralYes2.7%11.3%

Gilts ETFs
Multi Units France Lyxor ETF IBOX £ GILTSGILSGBpNeutralYes8.3%26.0%
iShares UK Gilts 0-5 yr UCITS ETFIGLSGBPNeutralNo1.5%4.2%
iShares Core UK Gilts UCITS ETFIGLTGBPNeutralNo8.4%25.7%
Lyxor ETF iBoxx UK Gilt Inflation LinkedGILIGBPOverweightNo11.0%41.1%

Source: Bloomberg and Saxo Group
*Table shows 5-year total return or since inception

Energy bonds to benefit from reflation

The recent wave of Covid-19 cases has slowed down economic activity, disrupting demand and prices for crude oil and fuel once again. Although the market is fast in envisioning a renewable era, the transition to green will be gradual, and in the foreseeable future we will still need to rely on the traditional energy sector. Thus, a considerable part of investments will need to continue to flow to sustain existing energy supply levels. Governments will need to continue to support struggling energy companies through stimulus packages to ensure that there will not be disruption to economic activity. Once the economy is on a stable path to recovery, we can expect energy demand to be restored and the sector to recover quickly.

The bond market offers many opportunities within this space; however, it is crucial to cherry-pick. Energy companies with a contained net debt to EBITDA will be able to weather depressed energy demand spurring from low economic activity. At the same time, state-owned companies will be better positioned to take advantage of stimulus packages. In a previous analysis, we found exciting opportunities within Lukoil, Gazprom and Ecopetrol, which offer competitive yields for their notes. On the other hand, while Pemex offers one of the highest yields in this sector, the company is poised to suffer together with Mexico's government bonds from a massive debt burden, and a dependency on the capital market to service its debt.

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