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Chris Iggo: How AXA IM is reacting to the risk of a “bond meltdown”

05 July 2015

The bond chief investment officer explains how the firm is looking at the fixed income market, given the heightened volatility and uncertainty that has dominated sentiment over recent months.

By Chris Iggo,

AXA Investment Managers

We are taking a more cautious stance in fixed income portfolios as we enter a testing period for the markets. If the Federal Reserve increases interest rates, it will be the first time it has done so for over nine years.

It is difficult to know how markets will respond, knowing that this will be the beginning of a process of normalisation. At a later date, the Fed may even begin to unwind its balance sheet.

Total returns in fixed income markets turned negative in the second quarter as investors retreated from negative yielding core assets in the euro area and economic data confirmed a reduced risk of outright deflation.

Core government bond yield curves steepened and forward rates moved sharply higher as more uncertainty about future monetary setting became reflected in interest rate curves. This happened even though the European Central Bank (ECB) continued to stress that its quantitative easing (QE) programme would remain in place until at least September 2016.

Performance of index in 2015

 

Source: FE Analytics

Of course, this also means that official interest rates in Europe will remain negative over the same period, so it is difficult to argue that the increase in bund yields from 8 basis points to 80 basis points reflected a change in short-term monetary expectations. Instead, the move reflected a shift in long term valuations in fixed income.

As economic growth forecasts for Europe were revised higher and evidence suggested that inflation was bottoming out, it became clear that long-term bond yields were too low and entering into the market at those levels would guarantee a capital loss. As such, Q1 saw some rapid re-positioning in the market along with a change in net government bond and corporate bond supply. Poor liquidity exacerbated the moves.

In our view a 10-year German bund yield of closer to 1 per cent makes more sense than a negative yield so the correction can be seen as a healthy one. There remains a QE premium in European fixed income but valuations now better reflect the improved economic outlook. As we said last quarter – if QE works, yield curves will be steeper.


 

The rates move began in the euro area, but it soon led to higher US treasury yields. The US economy had a soft patch in Q1, but looks to be recovering strongly. The Fed has continued to state that it needs to see evidence of inflation moving higher. Since the global oil price bottomed in February, the US consumer price index (CPI) has risen by 1 per cent – an annualised rate of 3 per cent. 

Moreover, there are signs of wage increases now becoming more widespread while the housing market has seen an acceleration in activity this spring, pushing up rentals and adding to headline CPI risks. GDP growth is expected to be close to 2.5 per cent this year with inflation for the year as a whole close to above 2.0 per cent. This means the Treasury curve is still fundamentally expensive.

We expect core bond yields to remain in a rising trend. In the short term, the extent to which this happens depends on Greece and the US economic data. Yields have risen a lot since late April and there is potential for lower yields if the Greek impasse leads to a general bout of risk reduction and flight to quality.

However on a three-month view, we could be close to the first hike by the Fed and the Bank of England (BoE). As such, our expectation is for higher benchmark yields in the US and UK and for steeper curves and volatility that is higher than it was in Q1.

For Europe, a shortage of supply in government bonds in July and the continued presence of the ECB might cap any increase in bund yields. However, we do not think yields will re-test their April lows. Uncertainty in Europe means having a strong view on duration is not easy while in the US and UK curves it makes more sense to be set up for higher yields and steeper yield curves.

Investment grade indices had negative returns in Q2, but this was mostly because of the movement higher in underlying yields. For much of the time spreads were unchanged. However, in recent weeks spreads have widened, partly in response to uncertainty around Greece with moves being made worse by poor liquidity in the market.

Our views on credit have not changed materially over the last quarter and in our base case we see spreads remaining unchanged to a little narrower in Europe and the UK, and widening a little in the US.

In the same vein, we remain positive on high yield with superior returns expected from both US and European high yield given the attractive carry relative to investment grade and the more in-built resilience to higher US interest rates.

High yield loans are also attractive with spreads close to 5 per cent. The ongoing search for yield and increase in collateralised loan obligation (CLO) issuance will support the demand for good quality high yield loan paper; allowing spreads to narrow somewhat. We also continue to see good value in senior and mezzanine CLO tranches in Europe.

Some increase in issuance in credit is likely in the wake of a Greece resolution and if core rates do rally again in the summer.

The key risks come from Greece and the Fed. If Greece leaves the euro, the direct implications on euro peripherals and credit are limited. However, there could be longer term geopolitical implications and credibility issues for Europe.


 

More important is the risk of general re-pricing in fixed income from a more aggressive Fed. A faster pace of rate increases would have a negative impact across the asset class, including wider spreads in investment grade, high yield and emerging markets.

Our preferred asset classes remain peripheral debt, inflation linked bonds, credit and high yield. We continue to have a preference to be underweight core government bonds, with a bias towards underweight duration in the US and UK.

Return expectations point to a bias towards European fixed income rather than the US, given the risk of a Fed rate hike later this year.

The Greek situation will probably bring some value back into risky assets, but volatility is likely to remain high over the summer months, leading to reduced levels of credit risk in fixed income portfolios and higher cash levels.

Chris Iggo is chief investment officer for fixed income at AXA Investment Managers. The views expressed above are his own and should not be taken as investment advice.

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