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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. State Street Global Advisors 2 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 State Street Global Advisors 3 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 State Street Global Advisors Bloomberg Barclays Euro Aggregate Corporate Index. 5 European Fixed Income: Challenges For Investors In A Low Yield World ssga.com Marketing communication. For professional clients use only. State Street Global Advisors EMEA Entities Belgium: State Street Global Advisors Belgium, Chaussée de La Hulpe 120, 1000 Brussels, Belgium. T: 32 2 663 2036. F: 32 2 672 2077. SSGA Belgium is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Dubai: State Street Bank and Trust Company (Representative Office), Boulevard Plaza 1, 17th Floor, Office 1703 Near Dubai Mall & Burj Khalifa, P.O Box 26838, Dubai, United Arab Emirates. T: +971 (0)4 4372800. F: +971 (0)4 4372818. France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number 412 052 680. Registered office: Immeuble Défense Plaza, 23-25 rue Delarivière-Lefoullon, 92064 Paris La Défense Cedex, France. T: (+33) 1 44 45 40 00. F: (+33) 1 44 45 41 92. Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D-80333 Munich. Authorised and regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”). Registered with the Register of Commerce Munich HRB 121381. T: +49 (0)89 55878 400. F: +49 (0)89 55878 440. Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number: 145221. Member of the Irish Association of Investment Managers. T: +353 (0)1 776 3000. F: +353 (0)1 776 3300. 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Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich. Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-105.078.458. T: +41 (0)44 245 70 00. F: +41 (0)44 245 70 16. United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 2509928. VAT No. 5776591 81. Registered office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. T: 020 3395 6000. F: 020 3395 6350. 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 assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA’s control. Please note that any such statements are 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. State Street Global GlobalAdvisors Advisors 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. 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