Download European Fixed Income: Challenges For Investors In A Low Yield

European Fixed Income: Challenges
For Investors In A Low Yield World
Is the Bull Market Dead?
by Niall O’Leary, Head of EMEA Fixed Income Portfolio
Strategists and Rupert Cadbury, Fixed Income
Portfolio Strategist
Geopolitical concerns, expectations
for fiscal stimulus by the Trump
administration in the US and faster
rate hikes by the Federal Reserve
(Fed) have weighed on bond markets.
For European investors, this presents
new challenges in what is still a low
yield world. And navigating this
landscape will require conviction,
flexibility and perhaps a willingness
to consider new ideas.
Notwithstanding the torrid fourth quarter for bond markets,
2016 should be remembered as a year when European sovereign
bond yields plumbed new lows on the back of continued bond
buying support from the European Central Bank (ECB). At the
end of 2016, the ECB extended its Asset Purchase Programme
(APP) until December 2017, but cut purchases from €80bn to
€60bn a month from April. Arguably, quantitative easing (QE)
in the eurozone should still be supportive for sovereign bond
markets but other forces have proved more influential in
recent months.
For over a generation, we have witnessed ever-lower yields
in global government bond markets, with the bull market
extending back over 30 years. Many factors have played a part,
but the heavy emphasis on controlling inflation is recognised
as a key contributor. There have been periods when bond
markets sold off — as in 1994 when Alan Greenspan’s Fed
surprised the markets with its pace of interest rate hikes
and in the eurozone in 2012 in the face of the European Debt
Crisis — but lower-and-lower yields have been the norm.
Figure 1: Global and Eurozone Government Bond Yields
10
8
6
4
2
0
1987
1994
— Bloomberg Barclays Global Treasury
2001
2008
2017
— Bloomberg Barclays Euro Treasury
Source: SSGA, Bloomberg as of 28 February 2017.
Past performance is not a guarantee of future results.
In more recent years, unconventional monetary policy
measures (including QE) were deployed by the world’s major
central banks in the aftermath of the Global Financial Crisis.
These helped to push developed market government bond
yields to record lows, and into negative territory in some
countries; more recently though, bond markets have come
under pressure. The surprise presidential election success of
Donald Trump has raised concerns about inflation, but also
brings into clear focus potential geopolitical risks. The decision
to vote for Brexit and the failure to back constitutional reform
in Italy are two other examples, and it is not at all surprising
that investors are increasingly wary of political risk. With key
elections in the Netherlands, France and Germany in 2017 and
the rising popularity of anti-euro parties, a risk premium has
been returning to bond markets (Figure 2).
European Fixed Income: Challenges For Investors In A Low Yield World
Rather than trying to forecast the future, we should
acknowledge that we are at a point where returns from bond
markets are likely to be considerably lower than they have been
in recent times. We should also recognise that the market may
require a higher premium for sovereign risk in the eurozone
given geopolitical uncertainties, something we have seen play
out over the last few months.
Figure 2: Global, US and Eurozone Government
Bond Yields
2.5
2.0
1.5
1.0
Figure 3: Eurozone 10-Year Sovereign Spreads Relative
to Germany
0.5
0.0
Dec
2014
Jun
2015
— Bloomberg Barclays Global Treasury
Dec
2015
Jun
2016
Jan
2017
— Bloomberg Barclays Euro Treasury
2.25
1.50
— Bloomberg Barclays US Treasury
0.75
Source: SSGA, Bloomberg as of 28 February 2017.
Past performance is not a guarantee of future results.
0.00
-0.75
It is impossible to know whether we are now entering a
sustained period of rising rates, or perhaps even a bear
market for bonds. Some of the arguments supporting
the bear case include:
• Inflation expectations have risen in the US, UK and
the eurozone.
• Fiscal stimulus in the US this late in the economic cycle is
likely to put upward pressure on wages, given the low rate
of unemployment.
• The Fed is likely to hike rates faster than the market
anticipates, in part as a counterbalance to more
expansionary fiscal policy.
• Even in the UK and eurozone growth has looked
more resilient, despite the uncertainty of Brexit and
forthcoming elections.
• Quantitative easing is reaching the end of the road and
monetary policy is likely to be less supportive of bond
markets in aggregate.
Needless to say, there are counterarguments that run along the
following lines:
-1.50
Aug
2016
— France
Oct
2016
— Finland
— Spain
Dec
2016
— Italy
Jan
2017
Feb
2017
— Netherlands
Source: SSGA, Bloomberg as of 28 February 2017.
Past performance is not a guarantee of future results.
Interest Rate Sensitivity
In addition to the low return potential, there is an increasing
level of risk coming from interest rate sensitivity. This is best
illustrated by the impact of a 50 basis point (bps) interest rate
increase on the subsequent 12-month returns of global
Treasury indices. Figure 4 highlights how the Euro Aggregate
Index and two other major aggregate indices are far more
exposed to interest rate risk than at other times in history.
The same is true for investors in the Euro Corporate Index.1
They would fare only marginally better with a 12-month
expected return of -1.8% following a 50bps yield increase
(based on end-February 2017 data).
• It is only headline consumer price inflation (CPI) that is
rising and this is heavily influenced by base effects and
the recovery in oil prices.
• In the eurozone, core CPI (which excludes energy) remains
below 1%, and with unemployment still close to 10% the
potential for it to break higher seems limited.
• The ECB APP will run until the end of 2017, and ECB
President Mario Draghi has reaffirmed his stance that the
central bank stands ready to do more from a QE perspective.
(The flip side of this is that the Bundesbank is increasingly
calling for an end to ultra-accommodative monetary policy.)
• There remains a strong demand for bonds globally based on
regulation, the requirements of savers and demographics.
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European Fixed Income: Challenges For Investors In A Low Yield World
Going Deeper into Euro Credit
Figure 4: 12-Month Expected Return after 50bps
Yield Increase
%
4
2
1.6
1.0
1.4
0.8
0
-0.6
-2
-1.7
-1.9
-2.8
-4
-6
 Global Agg
-3.9
2005
 Sterling Agg
2010
2015
 Euro Agg
Source: SSGA, Bloomberg as of 28 February 2017.
Past performance is not a guarantee of future results.
The above forecasts are estimates based on certain assumptions and analysis made
by SSGA. There is no guarantee that the estimates will be achieved.
This Time is Different
There is of course the argument that unlike past cycles
“this time is different” and that future rate increases will be
more gradual. While lower official rates for longer help mitigate
the risk of negative price action from a policy rate increase, it
does not solve the issue of near-zero yields. Yield to maturity
is the best predictor of future return potential from a fixed
income security or portfolio, and the current outlook for
euro-denominated investment grade bonds is not attractive
in our opinion.
Strategic Options
What options can traditional investors in European
investment grade bonds consider? There can be no certainty
that bond yields will reset to a sustained upward trajectory
anytime soon. However, our analysis has shown that there is
little reward to be gained with yields at such low levels.
Individual investors’ risk tolerance and investment goals are
defining factors in the selection of any particular option, and we
have considered a number of readily accessible strategies that
may improve long-term investment outcomes:
• Going deeper into euro credit — harvesting the credit risk
premium down to the high yield universe.
• Diversifying globally — targeting the higher
yielding markets around the world.
• Higher beta routes — global high yield (HY) securities
and emerging market debt (EMD) represent high
yielding alternatives for investors with the
commensurate risk appetite.
Going deeper down the credit spectrum is one alternative to
low or negative yielding government bonds. However, the ECB’s
APP has raised demand for euro corporate bonds and the result
is that switching from the Bloomberg Barclays Euro Treasury
Index into the Bloomberg Barclays Euro Corporate Index only
provides a paltry yield pick-up of 0.22% for accepting the lower
credit quality associated with the corporate universe (Figure 5).
One of the attractions of switching out of treasuries and in to
corporate bonds is the reduction in duration (by over two years),
while at the same time picking up incremental spread of 124bps.
For investors whose primary aim is to remain in eurodenominated bonds and avoid negative interest rates, this
may be a viable option. But for investors with a greater risk
appetite, high yield bonds may present a more attractive option.
Figure 5: Euro Fixed Income Indices
Euro Treasury*
Euro Corp*
Number of Issues
350
2007
344
Duration (Mod. Adj.)
7.58
5.39
3.16
Market Value (€m)
5,905,129
1,714,359
202,028
Average Rating**
AA3/A1
A3/BAA1
BA3/B1
Yield to Worst
Euro HY*
0.57
0.79
2.50
OAS (bps)
78
124
314
Maturity
9.18
5.78
4.91
Source: Barclays, SSGA as of 28 February 2017 (Euro High Yield is 2% issuer cap
ex financials).
* FI indices: Barclays EUR Treasuries EUR Unhedged, Barclays Euro Aggregate
Corporate EUR Unhedged, Barclays Euro High Yield EUR Unhedged.
** Bloomberg Barclays Index rating used as an indicative index rating value. Rating
calculated as aggregation of indices from S&P, Moody’s and Fitch. Moody’s scale
is used for a reference level representation.
Diversification does not ensure a profit or guarantee against loss.
Euro high yield securities offer a yield of 2.50%, and one of the
long-term attractions of high yield is that it is less affected by
duration and is more a pure play on credit risk (for more see
European High Yield — Evaluating Opportunities in a
Low Yield World).
Diversifying into Global Assets
For eurozone investors, another option is to consider global
fixed income; this is a trend we have seen develop more in
recent times. Depending on risk appetite, investors can
consider everything from global government bonds to global
aggregate and more risky strategies such as global high yield
or emerging market debt.
Expanding beyond European government bonds into the global
treasuries universe brings specific benefits:
• Broader universe
• Higher yield to maturity
• Diversification away from the ECB’s QE programme and
gaining exposure to other monetary policy regimes
• Higher credit quality
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European Fixed Income: Challenges For Investors In A Low Yield World
Figure 6: Major Global Fixed Income Indices
Number of Issuers
Duration (Mod. Adj.)
Market Value (EUR, billions)
J.P. Morgan GBI-EM
Global Diversified^
Global Treasuries^
Global Aggregate^
Global Corporate^
Global High Yield^
50
2,346
1,556
1,449
21
7.80
6.89
6.55
4.20
5.02
22,750
42,183
7,849
2,247
731
AA2/AA3
AA2/AA3
A3/BAA1
BA3/B1
BAA2/BAA3
1.07
1.65
2.71
5.62
6.48
17
45
123
402
N/A
Maturity
9.38
8.71
9.00
6.56
7.38
10y Annualised Historical Return
(EUR Hedged) (%)
3.96
4.07
4.56
7.16
6.47
10y Annualised Historical Volatility (%)
3.04
2.80
4.80
11.00
9.71
10y Sharpe Ratios (EUR Hedged Returns)
1.31
1.46
0.95
0.65
0.67
Average Rating^^
Yield to Worst
OAS (bps)
Source: Barclays, JPM, SSGA, as of 28 February 2017.
^ F I indices: Barclays Global Agg Treasuries (EUR Hedged), Barclays Global Aggregate (EUR Hedged), Barclays Global Agg Corporates (EUR Hedged), Barclays Global High Yield
(EUR Hedged), JPM GBI-EM Global Diversified (EUR Unhedged).
^^ B loomberg Barclays Index rating used as an indicative index rating value. Rating calculated as aggregation of indices from S&P, Moody’s and Fitch. Moody’s scale is used for a
reference level representation.
Past performance is not a guarantee of future results.
Diversification does not ensure a profit or guarantee against loss.
Going deeper into the Global Aggregate world further increases
the yield to maturity by a modest amount, while also reducing
interest rate sensitivity and providing the broadest available
fixed income investment grade exposure. Arguably, this is the
ultimate fixed income beta.
The global credit universe offers a further potential boost
in yield, closer to 3%, in return for accepting a moderately
higher level of credit risk (Figure 6). Diversifying into global
fixed income carries foreign exchange risk, and the traditional
approach for bond investors is to implement a hedge strategy.
This is because currency risk can heavily influence, and even
dominate, bond returns (Figure 7).
It is paramount that investors understand the underlying
market structure when diversifying away from their domestic
markets. For example, the global treasuries universe is heavily
dominated by three currencies: Japanese yen at 30.1%, US dollar
at 28.2% and the euro at 25.3%. The dollar and yen together
account for around 62% of the global aggregate index, although
in this universe, the US dollar alone accounts for 45.2% of
overall currency exposure. These aspects require careful
consideration as they may present challenges and issues relative
to the investment goals. What we see is an increasing desire on
the part of investors to customise fixed income portfolios,
including or excluding risks depending on their investment
goals and rules.
High Beta Options
In a low interest rates environment, high yield and EMD are
viable options when reaching for a higher return. The global
emerging market debt as measured by the JP Morgan GBI-EM
Global Diversified Index had a yield to maturity of 6.48% at
the end of February 2017. While this is down somewhat from
the highs at the end of 2015, it is still well in excess of the levels
offered by euro treasury and corporate fixed income securities.
State Street Global Advisors
Figure 7: Foreign Exchange Return Contribution
3 Yr Return (%) based in Euros
50
40
30
20
10
0
-10
Global Treasury
(25.3%)#
Global Agg
(23.4%)#
Global Agg Corp
(21.3%)#
Global High Yield
(14.4%)#
Index (% EUR Currency Exposure)
 Currency Return
 Coupon Return
 Price Return
 Total Return
Source: SSGA, Barclays POINT, JP Morgan Data Query as of 28 February 2017.
Past performance is not a guarantee of future results.
# Bloomberg Barclays Global Treasury Index (EUR Unhedged), Bloomberg
Barclays Global Aggregate Index (EUR Unhedged), Bloomberg Barclays Global
Corporate Index (EUR Unhedged), Bloomberg Barclays Global High Yield Index
(EUR Unhedged).
The EMD segment may be an attractive solution in both the
hard and local currency universes. Over the last 10 years, the
segment has grown in size and strengthened in credit quality.
Hard currency EMD has similarities to the high yield risk
return profile, but with return coming from sovereign,
rather than corporate credit risk. Local currency EMD has a
significantly different risk return profile to other fixed income
instruments given the volatility of EM currencies. For more
on EMD please see Emerging Market Debt: Passive
Management on the Rise.
4
European Fixed Income: Challenges For Investors In A Low Yield World
Conclusion
With some familiar ‘old’ risks remaining and new challenges
emerging, investors cannot afford to relax their efforts. Low
yields remain the reality for European investors in traditional
treasury and investment grade bonds and this demands
attention and long-term planning. The spotlights should
not only be on the low potential future returns indicated by
depressed yield to maturity, but also on the significantly
increased systematic risk creeping in from growing interest
rate sensitivity.
At this time, investors should consider one or more of the
alternative options available to them, seeking to diversify
their portfolios away from the unfavourable fixed income
landscape in Europe. When considering these options,
investors should pay close attention to the risks inherent
in these exposures and ensure they are consistent with
their investment goals and risk tolerances. Fortunately,
there are attractive options still available for fixed income
investors outside the eurozone. Approaching them with the
required degree of sophistication should help to deliver the
desired outcome.
1
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Bloomberg Barclays Euro Aggregate Corporate Index.
5
European Fixed Income: Challenges For Investors In A Low Yield World
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The views expressed in this material are the views of Niall O’Leary and Rupert
Cadbury through the period ended 28 February 2017 and are subject to change
based on market and other conditions. This document may contain certain
statements deemed to be forward-looking statements. All statements, other than
historical facts, contained within this document that address activities, events or
developments that SSGA expects, believes or anticipates will or may occur in the
future are forward-looking statements. These statements are based on certain
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not guarantees of any future performance and that actual results or developments
may differ materially from those projected in the forward-looking statements.
Investing involves risk including the risk of loss of principal. Diversification does not
ensure a profit or guarantee against loss.
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Bonds generally present less short-term risk and volatility than stocks, but contain
interest rate risk (as interest rates raise, bond prices usually fall); issuer default
risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually
pronounced for longer-term securities. Any fixed income security sold or redeemed
prior to maturity may be subject to a substantial gain or loss.
International Government bonds and corporate bonds generally have more
moderate short-term price fluctuations than stocks, but provide lower potential
long-term returns.
Investing in high yield fixed income securities, otherwise known as junk bonds, is
considered speculative and involves greater risk of loss of principal and interest
than investing in investment grade fixed income securities. These Lower-quality
debt securities involve greater risk of default or price changes due to potential
changes in the credit quality of the issuer.
Hedging involves taking offsetting positions intended to reduce the volatility of an
asset. If the hedging position behaves differently than expected, the volatility of
the strategy as a whole may increase and even exceed the volatility of the asset
being hedged
Past performance is not a guarantee of future results.
Index returns reflect capital gains and losses, income, and the reinvestment
of dividends.
All the index performance results referred to are provided exclusively for comparison
purposes only. It should not be assumed that they represent the performance of any
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