Market Outlook Q3 2019: Our view on fixed income

In a world of moderate growth and ample liquidity provisions from generous central banks, we prefer credit risk to duration risk. We favour euro-denominated low-investment grade bonds, hard-currency emerging market corporate bonds and US high-yield & low-investment grade bonds.

With interest rates set to remain low, risky assets will rule the roost
In a world of moderate growth and ample liquidity provisions from generous central banks, we believe that risky assets will rule the roost. On the fixed income side, our preference is for credit risk over duration risk. We favour euro-denominated low-investment-grade bonds, hard-currency emerging market corporate bonds and US high-yield bonds. 

In Europe low-investment-grade bonds provide a pick up 
Given the implosion of European inflation expectations, the bond market is discounting either a new asset purchasing programme from the ECB or rate cuts, or both. With inflation expectations having fallen below the low of 2016 (1.3%) comments from ECB President Draghi at the June Sintra conference have added fuel to investors’ hopes for easier monetary policy (see below the graph of the 5-year forward 5-year inflation swap rate that the ECB describes as the single-best indicator for market-based long-term inflation expectations). 

We upgraded euro-denominated low-investment-grade bonds to Overweight in February 2019, and believe that they still offer a good alternative to the negative returns in the money market and the meagre yields investors receive from higher quality debt. We do not currently expect the ECB to deliver on rate cuts and if they resume asset purchases, corporate bonds will benefit. 

European market-based long-term inflation expectations are below the 2016 low Source: Bloomberg Finance L.P., Julius Baer Fixed Income Research

In the US we go even further down the credit curve, preferring high-yield bonds
In April 2019, we upgraded US high-yield bonds to Overweight in anticipation of benign credit losses and low refinancing stress. The current US economic environment (moderate economic growth and low inflation) is perfect for risky bonds - not too hot, not too cold but as Goldilocks famously said: “just right”. 

Given our expectations that the US Federal Reserve will now deliver a precautionary cut in July, we maintain our call for US high-yield bonds which we expect to see benefit from a further slight spread compression. We do not believe that we will see a US recession in 2019, and we expect to see continued money inflows into the high-yield sector induced by the lower Fed Funds rate and lower Treasury yields. 

Moody’s rating agency recently surprised the market with a big upward revision in the 12 month baseline forecast for US speculative grade issuers, doubling the default rate expectations to 2.7%. Given that the average yield rating of US high-yield bonds over US treasuries is 3.8%, we believe that this is more than adequate compensation for the default risk.

Emerging markets have delivered superior returns over the long term
We moved emerging market (EM) hard currency bonds to Overweight in September 2018. The rally since then has reduced yields but the yield carry remains high, especially in an environment in which the “search for yield” is the global mantra. The risk-return relationship for bonds has improved as the relatively high carry provides a good downside cushion while generating an income for investors at the same time. Technicals have also been favourable. Net new debt issuance in the corporate sector has come down significantly in the last year as companies chose not to issue debt in unfavourable conditions. EM corporate refinancing risks also appear to be manageable at this stage. Given our forecast of slightly below-trend global growth, we see the sector delivering attractive returns going forward. 

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