Fixed Income Specialist, Saxo Bank Group
Summary: Despite the current, Fed-fueled rally, our late-cycle economy will inevitably draw nearer to recession. Investors looking to diversify, however, still have ample time, and bonds should be a top priority.
It is important to note, however, that the rally seen over the past few days was only induced by the market’s expectation that the Fed will hold off on tightening, or even ease, amidst a global growth slowdown and alongside a falling equity market. What investors are ignoring, however, is that the current cycle started long ago and will inevitably end.
The only relevant question at the moment is how far we are from recession.
This sounds dramatic; perhaps this is natural for an Italian among Danes, but I am not interested in drama for its own sake. The Fed chair’s remarks represented a long-awaited ‘reality check’ with regard to markets, and his comments regarding flexibility and the like indicate a central bank that will carefully parse the data before making a move. All in all, Powell sounded like a central banker in control. But is he?
We believe that the Fed has little control over what it is to come; the damage has already been done. Whatever measures the Fed will take will be done to delay or anticipate a recession, but avoidance seems highly unlikely.
Why is this?
In 2018, central bank monetary policy and headlines over a possible trade war between the US and China were the two elements driving market performance. This year, a global economic slowdown will occupy an even more important role. Unlike policy and trade war, there is no quick remedy to slowing economic growth. Investors have to arm themselves with patience and understand that there is nothing the Fed, the European Central Bank, or the Bank of Japan can say or do in order to reverse this course of action. If the global order of things, and here we refer to central banks, politics and the economy, fail to operate in the same balance as they once did, then recession is coming.
This does not mean you should panic. We may be moving towards recession but it it not here yet, and you have all the time necessary to reorganise your portfolio in order to diversify and create a cushion. It is key to understand where risk and opportunities lie given our present circumstance, and make the right choices.
We believe that the fixed income market offers many exciting opportunities. Most importantly, bonds will provide a buffer to diversified portfolios wherein equities will most likely suffer from increased volatility. We also believe that short maturities up to three years are the preferred choice due for one key tactical reason: as the market corrects, bonds will continue to provide a specific yield until maturity. Once that the bond has matured, the correction should have already occurred, giving investors the opportunity to invest in other names which would hopefully then be cheaper than they currently are.
The US corporate space has become particularly accessible, especially when looking at the pick-up spreads that corporate bonds have over Treasuries. It seems possible, in fact, to enter investment grade names that offer at least a 150 basis point pick-up over Treasuries, translating to a solid 4% in yield.
The juicier returns can be found in battered sectors such as car manufacturing. Automobile companies have suffered greatly due to US-China trade war headlines, but if it is true that we are moving toward a resolution, we can expect this sector to stabilise even if the economy continues to slow.
Among these companies it is possible to find Ford Motor 3.813% with maturity in October 2021 (US345397ZH93) senior unsecured bonds that offer 270 bps over Treasuries, translating to a yield of 5.24% for only two years and 10 months until maturity. Investors looking for shorter durations will find the Ford Motors 2.681% bond with maturity January 2020 (US345397YE71) even more interesting, offering around 4.4% in yield and trading below par. Not too bad for a triple-B rated bond!
The concern is that if the trade war escalates, this bond could be downgraded to junk. This is why investors are not afraid to look for opportunities in the high-yield bond space. Although downgrade risk in conditions of market volatility and uncertainty remains high for all type of bonds, high-yield bonds are already junk, and therefore are less sensitive to a potential transition between the investment grade and high-yield spaces while providing a better yield.
This, however, is not what is happening with Ford. As a matter of fact, lower-rated Fiat Chrysler bonds, which straddle the high-yield/investment grade borderline with Moody’s giving the company a rating of BA3, S&P giving BB+ and Fitch rating it at BBB-, are currently trading higher than Ford. Just for example, the Fiat 4.5% April 2020 bond (US31562QAC15) offers only 175 bps over Treasuries (4.30% in yield) for one year and three months maturity.
This is a very interesting point, which highlights the fact that investors are currently focused on the firm’s underlying assets.
This is a clear sign that the market is concerned by the prospects of recession and a possible increase in default rates. Thus, a flight to quality in the current market situation is not premature, it is necessary.