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Four things bond investors should be looking for after the Greek deal

14 July 2015

Now that a Greek bailout deal has finally been reached, AXA IM’s Chris Iggo lists four themes that fixed income investors should be focusing their attention on.

By Lauren Mason,

Reporter, FE Trustnet

Bond investors should be focusing on reflationary trade, the hunt for yield and avoiding rate risk among other potential headwinds, according to AXA IM’s Chris Iggo (pictured).

The chief investment officer for fixed income says that, now eurozone leaders have offered Greece a third bailout, those that are invested in bonds need to be looking at areas of the market that have either been impacted by the decision or simply been overshadowed by other, more prominent headwinds.

In the below article, FE Trustnet explores Iggo’s most important themes for fixed income investors to keep a close eye on and how to play them.


The search for yield isn’t over

While many investors and financial experts remain cynical about the Greek deal and how much it will really boost markets, Iggo argues that it has drawn attention to other potential headwinds in Europe that had previously been pushed to one side.

“It has been an unedifying spectacle and has sharpened the focus on some of the euro area’s structural fault lines – Franco-German relations; the tensions created by giving up sovereignty and still wanting a democratic mandate to govern a nation state; the shortfall of real integration,” he said.

“However, if Greece starts to implement what it has promised and Europe starts to send money, then markets will put these things on the back burner. And what are we left with? We are left with a bond market that remains expensive and dependent on the combination of extremely accommodative monetary policy, demographics and regulation to sustain the valuations that we have reached in recent years.”

What’s more, Iggo says that market positions in Europe are likely to remain crowded as quantitative easing continues, meaning that money could flow into higher-risk areas of the market as investors search for yield.

Examples of areas that he predicts will be popular are European peripheral bond markets, high yield bonds, subordinated financial debt and collateralised loan obligations (CLOs).

“Certainly in the traditional fixed income sectors there is not much yield but short-termism and the modest widening we have seen in credit spreads in the last few weeks will see money flow back in,” the chief investment officer said.

“Thus, the fixed income contradiction will return – supposed safety of the asset class leads to crowded positions chasing too low yields with too little liquidity to get out when things change. And, by the way, returns will be low. Year-to-date, most bond asset classes have delivered negative total returns.”

Performance of sectors in 2015

Source: FE Analytics

 

Emerging market fixed income

Emerging markets have been shunned by many investors in favour of developed markets over recent years. A series of macroeconomic headwinds including a strong US dollar, weak oil and commodity prices and fragile markets in Brazil, Turkey and Venezuela, not to mention the mass stock sell-off in China, have created a general negative sentiment towards the region.


Performance of indices in 2015

Source: FE Analytics

However, Iggo says that emerging market fixed income hasn’t been a bad place to be over recent months.

“The hard currency index has returned 1.7 per cent this year, just behind the US and euro high yield and ahead of investment grade and government bond indices in developed markets,” he said.

“There has been little ‘Greece contagion’ on EM and valuations are attractive. On the local currency side the strength of the dollar remains an issue – and not just for emerging market currencies, I might add. Add in recent volatility in the Chinese equity markets and it is easy to understand why many investors remain underweight in emerging market fixed income.”

As a result, Iggo believes that this could be a reason for investors to start increasing their exposure to emerging market bonds. He argues that it is not a crowded asset class, so it shouldn’t be impacted by major outflows if the Federal Reserve become more aggressive and hike rates.

What’s more, he points out that Chinese growth could well stabilise next year and more competitive currencies could boost emerging market growth.

“In a global search for yield, emerging markets seem to have been somewhat ignored in recent months, but fundamentals for emerging markets corporates and many sovereigns are relatively strong,” Iggo added.

 

The reflationary trade

Iggo says that, because quantitative easing is deployed to create inflation and combat deflation, risk taking at a macro level is encouraged via mass balance sheet expansion. This in theory generates jobs and inflates the price of assets, which could spread into goods and services.

“Central banks might continue with QE until inflation does pick up. Thus, we still like inflation protection from investing in real assets or inflation-linked assets,” he explained.

“In the bond markets there has been some increase in break-even inflation rates but this trade stalled in Q2 at levels that are still below central bank desired inflation rates. Break-evens tend to go up when high yield is also performing well.”

However, he warns that inflation-linked bonds can be risky because of the added duration risk if the investor is not holding the asset to maturity. Therefore, Iggo believes that investors should be hedging the duration.


Avoiding rate risk

While Iggo doubts that the Federal Reserve would put a rate hike on hold if Greece left the eurozone, he does believes that it might if the Federal Open Market Committee (FOMC) doesn’t believe the US has reached “escape velocity”.

“If the Greek deal holds then the Fed is back in play for September. If the Fed does feel ready to start normalisation then it is likely to announce several rate hikes over the next year,” he reasoned.

“Let’s say at least three 25 basis point increases in the Fed funds rate. If the yield curve moves in parallel with the first few Fed rate hikes then there will be negative returns across the curve. The yield curve may actually steepen which would worsen the outcome along the curve.”

Based on the assumption that the Fed will tighten monetary policy, Iggo believes that short duration has to be played in the US treasury market, unless the US economy slows down and deflation concerns re-emerge.

While he says that this is plausible because of the plummeting market in China and the weak commodity prices at the moment, Iggo believes it is unlikely that the US yield curve will do nothing more than carry return at best.

“If the US economy is displaying signs of being close to requiring some increase in interest rates then the UK is right there too,” he added.

“A tighter labour market, some evidence of wage increases and a Q2 bounce-back in activity are common characteristics. Inflation is low in both economies and that may be the reason why central banks hold off, but there is little upside for government bond investors. At least in investment grade [IG] credit there is more to go for – the IG yield in the US and UK is currently 3.4 per cent.”

While Iggo says there is protection in the credit market due to spreads of between 140 and 150 basis points, he advises that remaining at the short end of the maturity curve would be a better option.

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