Markets had a late summer feel to them last week. But there was enough going on to keep us challenged.
Real yields remain of particular interest to me. Last Tuesday we saw the longest dated UK index linked government bond hitting a new yield low of -2.5%. Why was this? Issuance of index linked bonds is presently low and there was some LDI buying – with an exaggerated effect in thin markets. More fundamentally, some investors are concerned about inflation – and index linked bonds offer a simple hedge. But the price of this protection is high. If we assume that the inflation reference index rises by 2.5% a year then the redemption price of a long-dated index linked gilt will be below its current price – not a good return over 40 years or more.
Market headlines have been dominated by Fed tampering talk ahead of Jackson Hole. The reality is that markets know that tampering is coming and that $120bn asset buying per month is not going to last. What happens next? A resetting of expectations, slightly higher bond yields, a sell-off in risk assets – but all contained by real yields. Unless we see a material move higher in real yields, on a global basis, then the necessary conditions for a sustained fall in equities and wider credit spreads is not there, in my opinion. When your choice is between a negative real risk-free rate and some prospect of a positive return, albeit with higher short-term volatility, unconstrained investors will still see value in equities and credit. But again, it depends on risk appetite, holding periods and a belief that capitalist model has not been undermined by Covid.
One argument which I hear more of these days is that credit needs a high risk premium (significantly higher than that for default risk) because of illiquidity i.e., the ability to transact at or near to current market prices. I welcome this view – as it allows our clients, with a medium and long-term horizon, to get better returns. Is this different in open-ended funds, with daily pricing? Not really, what we are able to offer is significant issuer diversity, an attractive mixture of unsecured credit bonds from global leaders and secured bonds from asset rich issuers and yields generally materially above benchmark indices. It is not rocket science. Let your clients know what you do, spread risk, do your credit analysis, embed security at attractive valuations, and focus on the medium term. This does not guarantee success but I believe it certainly shifts the odds in your favour.
Cash and government bonds
Global nominal yields trended higher last week. Musing on Fed policy and stabilisation in commodities and equities was enough to reverse the trend of previous weeks. Overall, data was mixed and there is certainly evidence of a Delta impact in the southern states of the US.
UK 10-year yields rose towards 0.6% whilst US rates also firmed, with 10-year yields moving to 1.35%. Euro area yields remained low but we did see German rates becoming a bit less negative at -0.4%, which had a knock-on impact across the region with France, Italy and Spain mirroring the move.
Cash rates did not change much but sterling recovered a bit to 1.37 against the US dollar.
Investment grade credit spreads enjoyed more of their summer lull. Even when sentiment is negative the refrain is that the market is weak – except in the areas we want to buy. High yield spreads recouped some of their losses last week, with spreads generally 10-15 bps tighter. We will have a better insight into market conditions when issuance returns in September.
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