Bond Market Commentary
Bond Market Commentary
The global bond markets in 3 charts
By Benjamin Streed, CFA
August 22, 2016
This version of the weekly commentary is going to focus less on descriptive paragraphs of text and will instead provide core charts/graphs and other visuals. Why? In this environment it seems that a picture is “worth a thousand words” as they say. Below are three charts that give a quick summary of what is influencing the global bond markets and the things investors should pay attention to as we wrap up the year.
First, let’s confirm the worldwide phenomenon that is the ongoing search for yield. With Europe, Japan and the UK now engaged in historic quantitative easing (QE) programs, investors around the globe are expanding their horizons (quite literally) and putting money wherever they can find yield. The chart below, via The Financial Times shows the massive uptick in fund flows this summer towards emerging market debt. This search for yield makes sense (for those that can accept the additional risk inherent in EM debt): the Bloomberg Developed Markets Sovereign Index yield sat at 110bp a year ago and now rests at a mere 49bp, a sharp move lower. Keep an eye on this trend, should EM flows remain strong it could indicate a global belief that rates could stay “lower for longer” even as the Fed hopes to hike rates sometime in 2016.
Second, as stated before in previous commentaries, US Treasuries are quickly becoming the proverbial “only game in town” for global investors seeking the combination of safety and positive yield. Could the ongoing bouts of QE overseas help keep a lid on long-term rates here at home? It’s very possible, especially if we look at how this has played out since December. The result of last year’s Fed action/liftoff was minimal, especially considering the global forces at work. Below is a quick visual of the US Treasury curve pre and post “liftoff”; the current curve is in green and the old curve is in yellow for comparison. The curve flattened thanks mostly to the large decline in longer-term rates (yellow bars below) while the front-end was only marginally affected by the Fed. Looking at this significant move lower in yields, one might be surprised to learn the Fed had begun “liftoff” at all.
Finally, here’s something to ponder as we consider what the future holds: the German Central Bank recently sold €10 billion of a zero coupon, 10-year bond into the market at a price above par. Think about this for a second, really let it sink in: no income/coupon and the bond costs more than it will return at maturity (issue price > par), sold at a negative yield of ~4 basis points (bp).
Meanwhile, the 10y US Treasury yields ~150bp and continues to see strong demand from overseas buyers who are battling negative yields for the indefinite future. In conclusion, the world faces a robust and ongoing search for yield and safety helping to keep a lid on US rates as international investors find solace in the US market. This is in conflict with the Fed who hopes to raise rates later this year.
Like nails on a chalkboard
By Doug Drabik
August 15, 2016
That same feeling of uneasiness felt by scrapping nails on a chalkboard happened AGAIN on the way into work. There was another “expert” proclaiming the ideal strategy is to continue to buy high dividend paying stocks and to run from bonds because they will get crushed when interest rates go up. As usual, the message is incomplete, timing dependent, not put in proper context and resonates the“stocks good… bonds bad” mentality.
Before I get on my soap box, let me clearly state that I have no issue whatsoever with high dividend paying stocks and that I believe they can be the absolute right choice depending on an investor’s financial situation and an investor’s asset allocation strategy.
How many years now have we heard the message that “bonds will get crushed when interest rates go up?” However many years we’ve heard it, is the number of years those expert proclamations have mistimed their statement. While it is true that as rates go up, bond prices will go down, the truth is we’ve been in a general interest rate decline for 34+ years, meaning that during all these years of warnings, bond prices in general have actually been going up. Not surprisingly, there never seems to be any mention of this.
As wonderful as it is that bond prices have risen, it is typically not the reason investors purchase bonds. The idea that buying stocks and buying bonds are framed in the same context is perhaps misguided. Each has its purpose and each addresses very different portfolio needs. Bonds are not typically purchased for their total return prospects but rather for their predictable cash flow and defined income streams. Preserving investor principal is most often more important than growth prospects for these allocations. The words “fixed income” are not arbitrary. The actuality is that “regardless” of interest rate movements (barring default), bonds will continue to pay that interest and produce cash flow as intended from the moment of purchase to the stated maturity.
When a bond is held to maturity, it does not get “crushed”, again, regardless of interim interest rate movements. At maturity, 100% of the face value of a bond is paid back. It is not a matter of market timing or interest rate prognostication. At maturity, an investor receives 100% of their bond’s face value… period.
Looking for yield? Welcome to the USA
By Benjamin Streed, CFA
August 8, 2016
As everyone is (hopefully) well aware at this point, central bank accommodation is arguably the primary driver of the global bond markets, having left general economic data to play second fiddle since mid-2009 when the Great Recession ended. Although we’ve had strong data on the jobs front here in the US, the effects are being muted by the global “big picture”. More than seven years on, and central bank activity is seemingly ratcheting higher, not lower, and global yields are falling to their lowest levels on record according to both Bloomberg and YieldBook data. Japan and the European Union are the major drivers of monetary stimulus (lower interest rates for longer) in the global marketplace, but recently the Bank of England (BOE) has stepped up its game by enacting its own accommodative monetary policy in the wake of the post-Brexit vote. In the last few weeks alone we’ve received updated from Japan, the BOE and the European Central Bank (ECB), all of which are in some form or fashion, helping keep a broad range of interest rates low. Keeping benchmark short-term rates low is run-of-the-mill at this point, so major central banks are now directly purchasing corporate bonds in addition to their ongoing support of low sovereign yields.
As the BOE put it, they will purchase £10 billion of sterling denominated bonds from investment grade (IG) issuers that make a “material contribution” to the UK economy. This is in addition to £60 billion in government bond purchases, thereby taking their balance sheet to £435 billion in the next six months. Direct purchases of credit are unique in the realm of central bank activity as they now directly affect more than just the nominal government yield (aka the base rate) but also the spread (the yield above the base rate) for corporate issuers. Simply put, central banks are large and atypical players in these markets and as they create money to purchase corporate debt they provide an unusual stimulus to the credit markets which should push spreads lower.
The marketplace now has low nominal/sovereign rates in many of the major economies overseas paired with likely lowered spreads for IG issuers. As we’ve written about before; overseas buyers continue to find value in both the US Treasury market and our credit markets thanks to our higher nominal yields. In effect, this should bode well for the US credit markets. As a reminder, 45% of global developed sovereign debt with a maturity <5 years have yields below zero while 35% of all maturities outstanding yield less than zero. This currently represents ~$9 trillion of assets and is expected to increase. According to Bloomberg and BofA index data, US IG credit (issuers domiciled here at home) now accounts for ~75% of all available yield worldwide. This massive change in the landscape for positive yield is helping fuel a surging demand for US assets: overseas investors are purchasing record numbers of US bonds with a massive surge that begin in late 2012. A minor inflow/outflow of $30 billion was typical over a six month period prior to 2013. Nowadays, this figure is always positive (they are buying) and now sits anywhere from $30 to $180 billion. Given this backdrop, is it any wonder why US rates remain at/near all-time lows despite more positive economic data and the potential for a second rate hike from the Fed? The search for yield expands well beyond the US, and the global demand for yield does not appear to be abating anytime soon. So long as overseas central banks are providing stimulus and the US remains the largest, most liquid and highest yielding developed nation on the planet there will likely continue to be strong demand for US assets.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.