Government bonds were under pressure last week as inflation, vaccine news and supply fears weighed on markets. A key issue for me over the next few weeks will be whether this rise in the risk free rate impacts on risk assets such as credit and equities.
At the moment both are showing resilience but the bull run in equities has been based on an exceptionally low discount rate of future cashflows and credit has been buoyed by strength in both equities and government bonds. Some caution is definitely justified at present.
Looking a bit more widely a headline that grabbed my attention was that China had replaced the US as the main trading partner for the EU. Covid has certainly accelerated trends – but the structural shift has been evident for some time. Asia has come through the present crisis better than Europe and the US, and the composition of equity and bond markets will increasingly reflect higher growth rates. We can see this in our own range of global credit funds where exposure to Asian and emerging market credit is rising.
These opportunities, not just in Asia but elsewhere, presents some big environmental, social and governance (ESG) challenges – for example with factors such as less stringent regulatory regimes, high carbon reliance, lower financial transparency, heightened governance issues, weak worker protections, changeable policy environments and rapidly evolving demographics. A key question is: how are we going to offer clients exposure to these developing opportunities whilst still maintaining high ESG standards? There is some good news: a recent Bank of America survey showed that of those emerging market companies that responded (80 out of 140), over 70% had an ESG policy and that 80% of respondents to the survey are covered by one of Sustainalytics, MSCI or Refinitiv. From my perspective we will continue to emphasise the importance of ESG across our credit range and expect the improving trend to continue in emerging market markets.
Cash, government bonds and currencies
The trend of marginally higher 3 Month GBP LIBOR continued last week as markets adjusted to the retreating prospect of negative rates in the UK. US 3 month LIBOR moved a bit lower. Sterling moved up, with the US dollar rate going above 1.40 for the first time since Q2 2018 and a far cry from 1.15 seen in March last year.
Global data last week confirmed that sector divergences remain stark, with manufacturing shrugging off lockdowns and services still struggling. In the UK the PMI composite rose to 49.8 after 41.2 –significantly above consensus. However, while the UK manufacturing PMI remained above 50, supply chain problems were cited by companies (shipping delays, high demand for raw materials, Brexit-related).
10 year UK gilt yields moved towards 0.7%, compared with 0.5% the previous week. Long yields also jumped higher with the 50 year gilt ending at 1.1% – double the yield at the end of 2020. All major government bond yields rose – and for the first time in a while the moves higher represented an increase in real yields rather than higher implied inflation.
We continue to run with a bias towards short duration but given the sharp increase in yields we are looking for opportunities to go more neutral.
Sterling investment grade credit indices moved lower over the week, reflecting the rise in gilt yields; credit spreads were broadly unchanged. Credit spreads are still lower than at the beginning of the year but the space of tightening slowed in the latter part of the week.
There was an interesting £1bn FRN covered bond issue from Nationwide last week – which our funds got heavily involved in. Rated AAA it has a maturity of 2031 and was issued at 40 bps over SONIA. I see this as a great example of getting some protection against higher interest rates from an issuer with a good business model, strong ESG credentials and offering high quality collateral.
Our short-dated strategies continue to perform well and there remains a strong bid in the market for short-dated bonds. The real challenge is to get an attractive yield when spreads are so low – but I think Paola’s team is doing a really great job here.
It was a very quiet week in our global funds – with little in the way of new issuance that attracted us. Investment grade markets moved lower with government bond prices whilst high yield was broadly unchanged with tighter credit spreads mitigating the change in government markets.
I still think that, on a medium term horizon, our high yield and higher income strategies will deliver better returns than government bonds. And so they should for the greater credit risk. Despite the rise in government bond yields last week I do not see much likelihood of higher official rates any time soon. This will keep short-dated yields pretty anchored to where they are now. The yield advantage, therefore, available in funds where income generation is high will offer material compensation for credit risk.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.