In the third of their regular podcasts this year, our Fixed Income Team discuss the recent sell-off in government bonds in many developed countries:
Government bonds: With central banks and governments committed to stimulus, does the sell-off represent a good buying opportunity or should investors tread carefully?
Corporate bonds: With government bond yields moving higher, how do corporate bond valuations stack up? Is this the time to add risk or an early warning sign of bigger problems to come?
Asia Pacific fixed income: With this region covering a vast number of countries and economic hubs, what is the impact of higher sovereign bond yields in the developed world? And are there any specific areas investors should be considering?
on today's podcast we'll be discussing the recent sell-off in government bonds and whether this is an opportunity or a concern for investors.
Amit Moudgil: Welcome to the Aberdeen Standard Investments Fixed Income Team Talk. I’m your host Amit Moudgil, I’m a Fixed Income Specialist here at ASI and on today's podcast we'll be discussing the recent sell-off in government bonds and whether this is an opportunity or a concern for investors.
I’m delighted to say that I’m joined today by Patrick O'Donnell, Investment Director in our Nominal Rates Team and a Portfolio Manager on our Global and European Government Bond Funds. Hi Paddy.
Patrick O'Donnell: Hi there.
Also we have on the Team Talk today Roger Webb, Deputy Head of Sterling Investment Grade and Aggregate. And Roger is also a PM on our Strategic Bond Funds as well as a number of our Sterling Investment Grade Funds. Hi Rog.
Roger Webb: Hi Amit.
Amit Moudgil: And finally we have a special guest today and I’m delighted to introduce Adam McCabe, Head of Fixed Income Asia Pacific. And Adam is a lead manager of a number of portfolios including our China Onshore Bond, our Asian Bond Fund and our Asia Pacific Income Funds. Hi Adam.
Adam McCabe: Hi Amit, welcome all.
Amit Moudgil: Excellent, so that's the introductions and before we kick off, as normal we like to ask our speakers a quick question just so our audience gets to know them a little bit better. And so today's question is very much based on a recent thing that popped up in the news, which was that a number of independent coffee shops have benefited from lockdown as people have got out of the house and decided to get themselves takeaway coffees. So my question to everybody is - what's your favourite go-to drink from a coffee shop or a café? And I'll kick off. For me it's not that exciting, it's pretty boring, but there's a practical reason behind that and I like to go for a flat white. And the reason that is I’m pretty slow at drinking, so essentially by the time I get to the end of that coffee, the flat white, it's still warm and it doesn't get cold, so that's the reason I go for a flat white. And Paddy, what about you?
Patrick O'Donnell: Yeah, I live in the country so I’m afraid I don't really have any local coffee shops that I can just pop out and walk to. But of them, if you force me to choose one, I’m afraid I’d might have a boring one as well and one would be just a latte but it would have to be a skinny one because with my physical activity being much reduced over the last year and my food intake being a lot worse and it would definitely have to be a skinny variety I think really.
Amit Moudgil: Yeah, absolutely, very good, and Rog - what about you, what do you think?
Roger Webb: Yeah, I’m a bit of a pest in a coffee shop as probably in other parts of my life as well. I like a fairly strong coffee, so I always ask for a double macchiato. But I also like a bit of extra milk, so macchiato comes with just foam I say could I have some extra milk please and then have to go through the whole process of describing how much milk in centimetres or inches of milk I actually want in my cup. So, as I say, a bit of a pain to the barista.
Amit Moudgil: Oh brilliant, yeah, that is an awkward customer for them. And Adam, what about you?
Adam McCabe: Well, as an Australian living in Singapore, I had to give up my coffee habits when I moved from Australia to Asia. Australia's got a pretty strong barista scene down there and it's a bit different up here in Singapore. Kopi – K.O.P.I, the traditional form of coffee in Singapore, and would you believe it the coffee beans are roasted with sugar, butter and oil. I would go for a Kopi-O, which is a black coffee, but you could get a KopI-C, which includes condensed milk. I don't think any of it’s very healthy.
Amit Moudgil: No, that’s brilliant - that's excellent.
Patrick O'Donnell: Sounds good though.
Amit Moudgil: It does - it sounds great, you learn something new every day. I have no idea, that's brilliant excellent, thanks guys.
Okay, so that's the what's your favourite over. So the topic for today's podcast was this recent sell-off in government bonds and whether we think this is an opportunity or concern for investors as we've heard just recently actually the Federal Reserve has reiterated its, you know, its forecast for growth and inflation, but at the same time is committing to keeping interest rates low and in some cases commentators are suggesting until 2024.
And actually, as we speak, that's seen the US 10-year treasury move above 1.7%,. and that's a level we've not seen since January 2020. And if you look at the longer dated bonds in the 30-year part, so the 30-year US Treasury that's gone above 2.5%, which is a level not seen since 2019. So guess, given those moves and that trend, I’d like to ask our panel today - what do you see in your own asset class within fixed income? This trend, is it an opportunity or a concern for you, and what we'll do is we'll kick off with Paddy first given it's probably a good point to start. Paddy?
Patrick O'Donnell: Yes, sure as you kind of alluded to it really depends on what asset class you're involved in but, my own specific one government bonds or if the short answer is – I think it's an opportunity mainly because beyond this year we don't think there's going to be you know self-sustaining inflation realised in developed market economies. The main reason for that is, there's going to be quite a lot of labour market slack and excess capacity in the economies as a result of the pandemic that we've all been experiencing and that's essentially going to keep a lid on inflation and how far yields can realistically move higher.
Obviously there's been quite a lot of stimulus pumped into the system at the moment. You know the Biden $1.9 trillion fiscal plan or support plan is certainly going to help matters. But I think the market is really looking at the bumper nominal growth and inflation that's likely to peak in the mid part of this year and is extrapolating forward into 2020, 22, 23 and beyond, which we don't think is correct or at least the risks are a bit more asymmetric here with valuations. If we look at long-term forward yields in the US, you know up north of 2.7% and approaching 3% in the face of the previous cycle peak of when the Fed was with heightened policy last time around was a 2.5% those yields are looking attractive because the likely peak next time around whenever we do see a hiking cycle again as you alluded to, the Fed if there is no hurry to begin to normalise policy, it's likely to be to be lower than that 2.5% that we saw last time round because of the amount of demented debt that's been added overall to the whole system.
In a more short term the latest leg of the movement nominal yields - or in global yields - has been led by real yields, which is seeing support for the US dollar increase, which tightens financial conditions and intense of a negative knock-on effect for risk assets at least in the short term enough that should bring flows back into safer assets like US treasuries and you're seeing the yield curve begin to pivot around the 10-year point so 10-30s is actually refusing to steepen in this in the sell-off so we think there's this value being created in the long end of the of the yield curve.
Amit Moudgil: And Paddy, what are you guys doing? So you see this as an opportunity? What are you guys doing in your portfolios? Can you give an example of how you're taking advantage of this particular trend?
Patrick O'Donnell: Yeah, well one I mentioned 10's 30's and the flattener is one, that's something that we've instigated in portfolios semi-recently and we still like that. I think when you know clearly the market is under some pressure at the moment and it has been for the last month or so and it tends to be what we've seen in the past is there tends to be an overshoot of you know, how far you think the market can get to, so I think it's one where we're watching for now but it's still we're getting to levels where we think you should be adding outright duration in the sort of longer term tenors and the curve should be getting to, we think an inflection point on the curve.
Amit Moudgil: Thanks Paddy and I guess finally, just what are the risks to your view? So clearly you talked about spare capacity, Biden stimulus, a lot of these things will likely keep, you know, yields in check. But is there any risk to your view like if things do get better quickly, and what kind of things are you worried about?
Patrick O'Donnell: Well yeah, I think it's a good question the you know if we look at things like permanent job losses on the amount of people that are signing on for weekly unemployment support, all those numbers are high and the risk is maybe when economies reopen fully and people are vaccinated and everyone actually goes back into jobs - the jobs that they had previously before they were you know put on furlough or made redundant - and then in that environment with a lot of pent-up demands because people have been, you know, middle classes have been sitting at home or not doing as much as what they're used to spending the money on - that maybe you do actually see more self-sustaining inflation and some of the manufacturing price pressures that we've seen, maybe they've become a bit more self-sustaining and get pushed on to the end consumer on an ongoing basis but that's a risk to the view.
Amit Moudgil: Brilliant, that's great, (end of time code) thanks Paddy, that's really insightful. And Roger, I guess from a corporate bond perspective where are, where do you see this trend in your space? Is this a concern for you guys or it's an opportunity?
Roger Webb: Yeah, thanks Amit. To be fair I think, almost the mirror of what Paddy was just talking about, we see the threat or the concerns in the near term of valuations upsetting the investment grade corporate bond market in particular. And then longer term, I think we could see ourselves presented with an opportunity to get into the asset class and other risk asset classes at more attractive levels.
I think put that in perspective, investment grade yields at the back end of 2020 were somewhere around 1.4% and today they're probably 50 basis points higher, so we've already seen a significant revaluation. The asset class looks more attractive but then if we see higher and higher yields than investment grade credit, relative to lower risk asset classes such as government bonds, those asset classes that Paddy has just been talking about look less attractive. So naturally investors will be attracted towards those lower risk but now higher yielding asset classes and away from corporate bonds, which have been a safe haven asset class for the last four or five years and one which has provided that additional yield and additional returns over government bonds in a fairly low volatility environment.
Amit Moudgil: So that's really interesting in terms of short-term and longer-term implications of this move in government bond yields. So what are you doing across your portfolios whether it be your Sterling portfolios or your Strategic Bond Fund? What kind of things are you doing to try and tap into this particular - let's say ‘scenario’ - that we find ourselves in?
Roger Webb: I think it's worth pointing out that everything that we're talking about today is valuations driven and obviously the big picture macroeconomic fundamentals are important. But it's also important to remember that loose monetary policy and stimulus from the fiscal side is positive from the macro environment. So by and large we're happy to move down the credit curve, that is to buy lower quality credit in investment grade - that means BBB credit - credit which has naturally some additional spread over government bonds to protect us against those higher yields. But also we're comfortable in buying that asset class because there is quality within that.
We haven't talked about the vaccine rollout and the end of lockdowns either and obviously in an environment where we're moving out hopefully from those lockdowns in Western Europe and the US in particular - we have done already in certain parts of Asia - then some parts of the economy will naturally improve quicker than others. And it's those parts of the economy that have done particularly badly in the last 12 months that are, if you like, operationally geared and therefore struggle really quickly when things turn off. They are similarly, they recover very quickly when the economy recovers and in that respect we're looking at areas like hotels and leisure, we're looking at airlines, airports, all of which have suffered dramatically and almost fatally in some cases through the pandemic but will benefit significantly from an upturn and we are paid in those areas for the risks that we're taking.
So those are the key areas - it's putting together a vaccine-related or a recovery portfolio - strategic bond for instance that you mentioned is probably 20% of our portfolio is in what we would call a vaccine theme that recovery theme which is retailers, real estate, hotels and leisure, airports and airlines and that's the sort of. The extension of that is, we're happy to drift down into high yield and high yields - higher quality high yield in particular - where it spreads to probably 300 or between 250 and 350 over government bonds we think offer some opportunities. Again revaluation of government bonds will impact that asset class as well so perhaps that's further down the road in the next two or three months that we get an opportunity to buy into that asset class at cheaper levels.
Amit Moudgil: I like that, I like the sound of that - the ‘vaccine theme’ - got a nice ring to it. So Roger, what are the risks then to that view? I guess they're probably the flip side of what Paddy was saying? I guess probably a worse recovery than you guys expect, that would be a risk to your view?
Roger Webb: Yeah possibly. I think a bigger risk in the near term is valuations driven, that we go through 2% yields in US treasuries. Back up in yields is acute and that will have a knock-on effect to risk assets much more severely than it has done. So far we see widening spreads in that environment.
If Paddy's thesis is correct and one that we buy into, particularly that we see a backup in yields but then inflation doesn't follow through, that presents us an opportunity. But if inflation does come through for the reasons that we haven't talked about as yet then that presents a risk, as does the downside scenario that the poorer economic backdrop that you've talked about as well - although that backdrop we've seen for several years now and negative economic backdrops aren't necessarily bad for corporate bonds in the stimulus measures that put in place have generally provided some support to the asset class. So I think I’m more concerned about inflation as a risk to the asset class - obviously not one that we necessarily believe will come through but one that would have an impact on valuations.
Amit Moudgil: And Adam, I guess in your world you have quite a lot of different portfolios and I guess geographies as well that you're looking at within, within your sphere. How are you looking at this trend - as an opportunity for you guys? Or as a concern?
Adam McCabe: It's interesting that you say that because you're right the Asia Pacific Fixed Income universe is very diverse and we have a raft of different opportunities across high-yield markets, lower yielding markets and of course markets like China that are beginning to open up to foreign investors. And really what that brings is a great deal of diversity in terms of opportunity and importantly it also gives us the opportunity to seek out, you know I guess, safe havens in a period of uncertainty, a period of uncertainty for global bond markets.
What I particularly call out in terms of an opportunity at the moment is that in the Chinese bond market the opportunity exists largely for a couple of key reasons. Firstly, largely because of different policy priorities the Chinese policy makers haven't necessarily followed that of the developed market – yes, they've provided support to their economy when it's been needed but it's been much more measured than the extraordinary policy stimulus that you've seen in in places around the world, such as in the US both in terms of monetary policy support and fiscal policy support for the economy. And so when global investors are fearing, either that, over-stimulus of the economy or indeed they fear the potential for a breakout in inflation in the developed world, one of the things that won't necessarily play out is either of those concerns being realised in China. In fact, what we see in China now with the 10-year yield around 3, 3.2 and an inflation rate at minus 0.2%, significantly positive real yields on a global basis, so no real need to be concerned about you know an adjustment in valuations led by other economic growth surprises or indeed an aggressive policy response led by inflation¬ - so we see value there.
The other thing to note is the Chinese capital market is opening, the Chinese bond market is being included in global indices in an increasing way. We've seen the JP Morgan GBIEM, the emerging market bond index, include China. We've seen the Bloomberg Barclays aggregate index include China and we're beginning to and we anticipate the FTSE world government bond index to include Chinese bonds in the index. So we're seeing a substantial amount of demand from foreign investors to include China in their portfolios. It's a large economy, it'll have a significant weight in a lot of these benchmarks and whether you're a passive investor or an active investor, the weight of China in in those benchmarks is just too large to ignore. If you're a passive investor, ignoring China introduces a significant amount of tracking error. If you're an active investor, ignoring China means that you're ignoring a relatively valuable or attractive market on a valuation perspective. So we see a great deal of support for the Chinese onshore bond market.
We anticipate that again some of the policies out of the US, particularly with the Fed being very supportive, the fiscal policy, the stimulus Paddy mentioned, we expect that demand for Chinese exports from the US and from the rest of the world as we emerge from the Covid pandemic will be very supportive for the trade in North Asia, trade coming from China and those positive impacts on the external balances will be supportive of the currency as well. So quite a positive story, low correlations, relatively higher yields, attractive valuations, see us, you know, well invested in that market.
Amit Moudgil: That's excellent, that's a really good, a good view of how, you know, different demographics and I guess different geographies as well sorry - actually can provide a very, you know different view of how things can play out, given you know there are certain dynamics going on, so that's really interesting.
I guess then Adam, what is the risk to that, to that particular view with using your China example - what would be the risk there or a concern that you have?
Adam McCabe: The Chinese economy is one that has long undergone adjustment and there's been a lot of focus around the accumulation of debt in the Chinese market, the way the policy makers allow for you know, debt to be I guess, managed through the cycle - particularly some of the excesses that have been undertaken by state-owned enterprises over the years. And so we see, we see a case that you know the policy makers while they want their economy to grow they want to support economic development, they also want to see a structural improvement in the financial sector particularly among the corporate and state-owned enterprise balance sheets and so we expect in China there to be a an ongoing increase in defaults in that sector. That doesn't mean to say that it diminishes anything from the positive story. We believe that the key opportunity in China is in the rate space, sticking close to the Sovereign - be that the Chinese government bonds, be they the policy banks - very close to the policy making priorities of the central government.
As you move down the credit spectrum, there will definitely be defaults and that will have an impact on the outcome for investors but nevertheless I don't think it's in the interest of the Chinese authorities to see financial conditions tightened too aggressively as a result of an adjustment in credit risk and credit pricing.
Amit Moudgil: That's great, thank you very much Adam. And so that that brings us to conclusion in our in our podcast today and I’d like to thank Paddy, Roger and Adam for their thoughts, really interesting to find out that depending on what aspect of fixed income you're looking at or you're investing in, there's clearly different opportunities and clearly different risks that you need to be aware of and consider going forward. And if there's anything else that we've learned today is that coffee is spelt slightly different in Singapore as well.
So thank you very much everyone for listening and feel free to get in touch with your Aberdeen Standard Investments sales contact should you need any further information on anything that was discussed today and if you'd like to find out more about our fixed income views or products then please feel free to subscribe to our fixed income newsletter using the link below in the podcast description.
I’d like say thank you again to the guys for their thoughts today.
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