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 Q2 2022: The End Game has arrived
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