Commentary by Kunal Mehta, CFA, senior investment specialist, fixed income
Fixed income markets remained relatively steady in August. Increased risk appetite underpinned demand for higher risk assets with sentiment supported by Federal Reserve (Fed) Chairman Powell’s dovish speech at the Jackson Hole symposium and further strong US payrolls numbers, among other factors. In contrast, commodities experienced some retreat from their recent rally as data showed growth in China was slowing. In Europe, there was some investor concern that the European Central Bank (ECB) could taper its asset purchases faster than expected, although it remains committed to further buying later this year. In the UK, the Bank of England (BoE) left its key policy rate unchanged but said modest tightening would be required, further down the line, if the economy recovered in line with Bank forecasts.
Monthly performance by market
|Global government bonds||Corporate bonds||Emerging market bonds|
|Bloomberg Barclays Global Aggregate Treasuries (USD Hedged)||Bloomberg Barclays Global Aggregate GBP Corporate (USD Hedged)||Bloomberg Barclays Global Aggregate EUR Corporate (USD Hedged)||Bloomberg Barclays Global Aggregate USD Corporate (USD Hedged)||Bloomberg Barclays Global High Yield (USD Hedged)||JP Morgan Emerging Markets Bond Index EMBI Global Diversified (USD Hedged)|
Source: Bloomberg Barclays, 31 July 2021 to 31 August 2021. Bloomberg Barclays Indices are used as proxies for each exposure.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
In the government bonds of developed markets, yields ended the month broadly higher across the board. The US, UK and German sovereign curves also demonstrated some flattening in the 2-10 year part of the curve. This was more pronounced in the UK than in the US or Germany1.
The credit markets were supported by a favourable risk backdrop and spreads continued to compress, modestly in the case of investment grade bonds and more significantly for high yield and emerging markets bonds. As the last batch of second quarter company results came through it was confirmed that more than 70% of European and US corporates had beaten analysts’ consensus expectations2. The results of cyclicals and energy companies were relatively better than those for defensive sectors. Despite some concerns related to the Delta variant of Covid-19, inflation and seasonality effects, company management teams generally appeared optimistic going into year-end.
Credit spread levels
Source: Bloomberg Barclays indices: Global Aggregate Credit Average OAS Index, Global Aggregate Supranational Index, US Aggregate Corporate Average OAS Index, Euro Aggregate Corporate Average OAS Index, Sterling Aggregate Corporate Average OAS Index, US Aggregate ABS Average OAS Index, US Aggregate CMBS Average OAS Index, Global High Yield Average OAS Index. J.P. Morgan EMBI Global Diversified IG Sovereign Spread Index, J.P. Morgan EMBI Global Diversified HY Sovereign Spread Index. As at 31 August 2021.
Supply in August was below prior years, for bonds issued both in euros and US dollars. Demand for new issues remained robust, with high book coverage ratios and limited new issue premiums. Investors’ appetite for ‘green/sustainable’ assets continued to be very strong. Central banks remained supportive though indications of tighter policy are emerging, especially in the US. New inflows into the market were lacklustre and we expect investors will likely continue to be sensitive to any further rates volatility in the face of economic recovery and inflation dynamics. Overall, the technical backdrop was supportive, due in part to liquidity and high cash levels.
Emerging markets (EM) began August in slow summer mode with spreads relatively flat before tightening towards the end of the month. Sovereign credits generated a solid return with spread tightening (1.4%) more than offsetting the loss from slightly higher US rates (-.4%). On a risk adjusted basis, after weakness in July, higher quality credit performed relatively better in August. Spreads for investment grade bonds tightened around 6% over the month compared with 2% for higher yield bonds3.
Lower quality credit remained well supported, especially in light of the International Monetary Fund’s (IMF’s) announcement of the largest-ever general allocation of special drawing rights (SDRs). This US $650 billion equivalent of artificial currency instruments from the IMF (built from a basket of national currencies) is intended to boost global liquidity. Several countries were reported to be considering using the IMF SDRs to pay down debt. The list included Colombia, which completed a transaction with its central bank at the end of the month.
Emerging market bond spreads
Source: Bloomberg, JP Morgan and Vanguard. 31 August 2019 to 1 September 2021.
As we had anticipated, sovereign issuance was light in August. This followed unusually heavy issuance in July, when yields were relatively more attractive and the prospect of rising interest rates was on the horizon. After accounting for amortisations and coupons, net sovereign supply was negative US $300 million. This helped to create a more technically supportive backdrop as inflows moderated. Hard currency funds experienced outflows for the first time since April (-US $400 million) while local currency funds had inflows of +US $700 million4.
EM local market performance was lacklustre. EM currencies began to recover from their downward trend as the dollar came under pressure from investors recalibrating expectations for Fed tapering. Meanwhile, central banks across various EM regions continued to tighten monetary policy on the back of inflation concerns
Peak global liquidity and central bank support is likely behind us and this will be a greater challenge for lower-quality bonds. We are constructive on credit exposure but many of the highest-quality issuers are now priced too richly, in our view, and lower-quality issuers are vulnerable to a change in market sentiment. We have therefore reduced our credit exposure over the last several months and are now focused on investment in credits that have upside potential based on improving fundamentals. Relative to more than a year ago, overweights towards specific sectors, business models or credit-quality segments offer little value in today’s market.
The move lower in US government bond rates in early July was surprising. Over time, we expect to see yields moving gradually higher. We expect core EU government bonds to continue outperforming US and UK bonds over the medium term as the Fed and BoE are expected to tighten monetary policy before the ECB. We expect EU bond yields to increase and curves to steepen.
In the credit markets, valuations continue to be high and while opportunities to add value exist they are less frequent and require higher conviction. Further, the upside is limited among high-yield and investment-grade corporate bonds but fundamentals are strong and yields relative to US Treasuries are attractive. Performance in these sectors will be driven by individual security selection.
Going forward, all eyes will remain on economic data, specifically that for inflation and the labour market, and the Fed’s reaction to it. We expect credit to remain well supported with substantial demand from a global investor base. Expensive valuations make us more cautious and we are holding ample liquidity to add exposure if prices adjust. We are focused on security selection to drive outperformance and robust risk management to build resilient portfolios for our clients.
In line with seasonal trends, EM sovereign issuance is expected to increase meaningfully in September and October. Estimates suggest that remaining sovereign issuance is about US $75 billion, which is about 35% of total 2021 expected supply. Issuers out of the Middle East and high yield Sub-Saharan Africa are likely to be more prominent compared to the first half the year which was dominated by Latin America. Given supply has been well telegraphed, we expect deals to be supported. We are positioned to take advantage of the upcoming new issuance and any dislocations it may create.
Elsewhere, we think opportunities exist in select local markets where central banks have made good progress towards implementing the full extent of planned and expected rises.
While higher-quality EM bonds offer limited value relative to other assets, greater value can be found in some idiosyncratic opportunities across the credit spectrum. We continue to look for credits that have already repriced on the back of issuance pressures or have reacted to the US Treasury moves and we are wary of those that have not. We are cautious about moving down in quality even if we do not foresee any new distressed sovereign situations over and above what is already known for the next few quarters. Technical factors around supply are also likely to be important for the high-yield segment as many investors are still meaningfully overweight in this part of the market.
1 Vanguard and Bloomberg Barclays as at 31 August 2021
2 Vanguard Fixed Income Team. Data as at 31 August 2021
3 Bloomberg, JP Morgan and Vanguard as at 31 August 2021
4 JP Morgan as at 31 August 2021
Important risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
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Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
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