There is no escaping the bond market

There is no escaping the bond market

Althea Spinozzi
Head of Fixed Income Strategy

Summary:  From safe investment to risk-on asset. Every corner of the fixed-income market is quickly losing value.

This quarter, the bond market will find itself short of options. What was deemed a safe investment last year is now too risky because inflation fears and optimism in the future are provoking a fast rise in interest rates. Everything ranging from sovereign bonds to emerging markets and investment-grade (IG) corporates is quickly losing value. The only part of the fixed income market which may close the first quarter of the year in positive territory is junk bonds. However, we believe that their honeymoon will be over soon as pressure is growing from the higher cost of capital.

Higher real yields threaten risky assets

Despite the fact that the US yield curve has been bear-steepening since last August, things are completely different this year because of what is happening with real interest rates. In the second half of 2020 nominal yields rose while real yields fell, providing companies with easy financial conditions. By December, the 10-year TIPS yields hit a historic low level at -1.1%. This trend suggested that the steepening of the nominal yield curve was entirely due to the reflation trade that saw nominal yields rising based on higher inflation spurring from better economic growth. However, from the beginning of 2021, something changed: real yields started to rise together with nominal yields, indicating that the cost of capital is suddenly increasing. 

The higher cost of capital negatively affects risky assets.  However, rates must rise fast and keep high to provoke a deep selloff. While there was ample time previously to reassess risk before higher nominal yields could trigger a considerable selloff, we now believe that such a selloff could materialise soon when 10-year US Treasury yields break and sustain trading above 2%.

Junk bonds at risk, but the duration event spurred by the reflation trade will be a bigger villain

Bond investors should be aware that something has changed in the past few weeks, making junk particularly dangerous: the correlation between Treasury yields and junk bond returns has turned negative, meaning that if yields continue to rise, junk bonds will tumble. It is exactly what happened in 2013 during the taper tantrum and in 2016 as Trump was entering the White House.

So far, junk bonds valuations have been supported because investors looking to build a buffer against rising inflation were forced into this space. Indeed, IG corporate bonds provide an average yield of 2%. With the 10-year breakeven rate at 2.2%, the yield that IG bonds provide will be completely eroded by inflation. Additionally, to find returns above 2.5% in the IG space an average duration of 15 years is needed, making one portfolio even more exposed to interest rate risk. On the other hand, in the junk bond space, it is possible to limit duration considerably as one can secure a yield above 2.5% with an average duration of 4 years. 

This is why, although we believe that junk will inevitably reprice as rates continue to rise, they still represent a vital part of a portfolio in managing and diversifying risk. However, it is necessary to pick credit risk selectively to avoid defaults, and to hold debt till maturity to secure the desired return amid a bond selloff.

We believe that duration will be a much bigger threat to the market in the second quarter of the year than credit risk. The extremely accommodative monetary policies that central banks enacted since the global financial crisis have led to lower yields globally. Investors have been forced either to take more risk or more duration in order to secure extra returns. Those who chose risk over duration might find themselves better positioned to weather a rise in yields, as coupon income will serve as a buffer. However, those that picked high convexity will find themselves with a portfolio that is overly sensitive to yield fluctuations. For example, within a month from its issuance, the French new 50-year government bonds (FR0014001NN8) that pay a coupon of 0.5% fell by 13 points. The Austria 2120 bonds (BBG00VPK2L82) offering 0.85% in coupon fell 30 points year to date. The Petrobras bonds with maturity 2120 (US71647NAN93) instead proved more resilient by falling only 15 points– just half of Austria's century bonds. Why? Certainly not because Petrobras is perceived as a safer investment than Austria, but because its coupon is much higher, around 6.85%, reducing duration substantially. It is important to note that uncertainties surrounding the company's leadership and risk deriving from Brazilian politics are affecting the Petrobras price as much as rising US Treasury yields.

Hence, this quarter it is key to beware of convexity, eliminating those assets that provide near-zero yields while continuing to build a buffer against rising rates with higher-yielding credit.

The divergence between central bank policies may provoke another European sovereign crisis

While the United States' economic outlook can accommodate higher US treasury yields, the same cannot be said about Europe. The divergence between the two economies stems from the fact that in the United States monetary stimulus goes hand in hand with fiscal stimulus, while Europe lacks the latter. Therefore, a rise in yields in the euro area could provoke a tightening of financial conditions faster than in the US, hindering a possible recovery.

The European Central Bank (ECB) is facing the problem that as US Treasury yields continue to rise, they will provide a better alternative to European sovereigns. Despite the selloff in the past few weeks, European sovereigns, including those of the periphery that are normally considered riskier, are still offering historically low yields, well below US Treasuries once hedged against the EUR. For example, Greek bonds, which are considered the riskiest in the euro area, offer around 0.85% in yield for a 10-year maturity. By buying into US Treasury bonds with 10 years of maturity and hedging them against the euro currency, an investor would be able to secure the same yield as Greece. However, the risk to hold US Treasuries versus Greek government debt is not comparable, making the latter exposed to rotation risk. 

As yields continue to rise in the United States, we believe that selling the periphery to enter the safe-haven bonds across the Atlantic becomes more compelling in risk/reward terms. Such rotation will test Greek and Portuguese sovereigns first, but it has the potential to spark a selloff across sovereigns in the periphery causing a market event that will see government bond yields rising fast. Such a selloff will not be comparable in intensity to the one of the European sovereign crisis of 2011, but it will need to catch up with the rise in yields across the Atlantic. This means we would probably see yields going from zero to 100 basis points quickly, tightening financial conditions dramatically in weaker EU countries. 

Within this context, the ECB's Pandemic Emergency Purchase Programme (PEPP) will prove inadequate. Right now, purchases under the program need to be proportional to a country's contribution to the ECB’s capital. Therefore, the ECB is buying a higher share of Bunds than other sovereigns, which would exacerbate scarcity of collateral without tackling a crisis properly in the context of volatility limited to the periphery. In light of this, we believe that amid another European sovereign crisis the ECB will need to tweak purchases under the PEPP in favour of the most volatile countries; at the same time, the European Union will be forced to take further steps towards fiscal unity. 

Quarterly Outlook

01 /

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

Saxo
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo is a registered Trading Name of Saxo Capital Markets UK Ltd (‘Saxo’). Saxo is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871. Registered in England & Wales.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

©   since 1992