Alternatives to cash and safe-haven bonds

Few investors expect any material returns from cash or safe-haven bonds, but many are still overweight these areas. While this is understandable given the many uncertainties that remain in the global outlook, we believe that there are many ways to improve the return potential without taking on excessive risk.

Here are some options:


Extending the duration of any cash deposit

Cash yields are low and are likely to remain that way for the foreseeable future in the UK and the US, while in the eurozone they may drop even further if the ECB decides – as we expect – to cut interest rates later this year.

While deposit rates vary significantly between banks, depending on their funding needs and credit quality, many offer much higher interest rates for somewhat longer-dated maturities.

In part, this is because they want to secure funding, but it is also because banks need to own low-yielding liquid assets (gilts in the UK) against any deposits shorter than three months, while this is not the case for longer-dated funding. Extending deposits from 3 to 12 months can often lead to a tripling of the rate, which can be attractive if the portfolio does not need the immediate liquidity.


Very short-dated European sovereign debt

The fact that one-year Italian bonds offer a higher yield than a 10-year gilt illustrates just how far the flight to quality has gone. Some of this may be exaggerated and we believe that for more aggressive investors there are buy-and-hold opportunities in short-dated European sovereign bonds. Italy for example pays 2.3 per cent for a one-year bill.

Extending duration beyond the two-year point thus does not add much to the yield, but can add significantly to the bond’s volatility. The eurozone periphery is likely to continue to generate many headlines, leading to potentially significant volatility for longer-dated bonds. Therefore, we prefer a buy-and-hold approach, which naturally favours shorter-dated bonds.


Short-dated senior bank debt in the eurozone

We have been buyers of senior bank debt with maturities of up to three years following the ECB’s LTRO, as this significantly reduced liquidity and default risk for eurozone banks in the short-term. Spreads have tightened significantly in past months, even if they have bounced somewhat recently.

Bank spreads are now at, or slightly tighter than, their sovereign spreads, which is a very rare phenomenon. Therefore, we think any further spread tightening requires sovereign spread tightening. We thus maintain our constructive view on one-to-three-year senior bank bonds, but consider them as a buy-and-hold carry play rather than a tactical trading idea.


Medium-dated non-financial investment grade bonds

Non-financials still look attractive in our view, in spite of past spread tightening. With a five-year gilt trading at 1.1 per cent, a spread pickup of 2.5 per cent in investment grade can more than triple the yield.

Investment grade credit tends to do well in an environment where economic growth is at or slightly below normal, as long as it remains positive. In such an environment, investment spending is low and companies do not feel tempted to lever up.

US non-financial leverage, for example, is now near the lowest level in 20 years, with the exception of 2006, while spreads are still higher than at any time in 1999 to 2008.

We maintain investment grade as an overweight in most of our portfolios. However, we limit our duration to five years, as we believe that rising longer-dated inflation expectations driven by global liquidity could hurt bond valuations.


Emerging market debt: local or hard currency?

We believe that Chinese economic data continues to point to a soft, rather than a hard, landing. As investors look to diversify away from the West’s problems and look for a yield pickup, we think emerging market bonds have a place in many portfolios.

We have for some time had a preference for hard currency-denominated emerging market debt over local currency debt. Hard currency debt has significantly outperformed local currency debt, but this may continue and we stick to our preference for USD-denominated debt.

Inflation pressures are starting to resurface in some emerging market countries, and although this is often linked to commodity or food prices, this may delay any further interest rate cuts that could have supported local currency debt. These inflation pressures, and global uncertainties, have also led to currency volatility, which impacts returns. Also, emerging market hard currency fund flows continue to dominate those that go into local currency funds.


High yield

High yield probably remains the most volatile sector in the fixed income area, although it has been remarkably resilient to sovereign volatility and global concerns. This is because companies have been carefully extending funding, conserved cash and limited investment spending, and hence kept defaults relatively rare. Ratings agencies expect the default rate to remain low, ending the year at 3 per cent. Therefore, we believe that high yield spreads will mainly remain a function of equity volatility and sovereign tail risk rather than default fundamentals.

European high yield clearly offers a higher yield than US high yield, but this is largely because of poorer economic growth fundamentals and the presence of subordinated and perpetual bank debt in the European index. We continue to hold a preference for US high yield over European high yield.


Yield enhancement ideas

Plenty of other yield enhancement opportunities exist in the form of structured products, which can be tailored to the risk appetite, maturity, liquidity and market view that are appropriate in any given portfolio. In equity portfolios, high-dividend strategies using quality stocks can help boost the income, and buffer the volatility if the stock selection is defensive. Of course, the risk profile of this strategy is straying further away from fixed income, and high-dividend strategies are subject to equity volatility.

William Sels is head of investment strategy at HSBC Private Bank. The views expressed here are his own.