“Given the prospect of a significant move up in rates, we maintain our neutral rating on High Yield bonds, where credit spreads should provide some buffer to the adverse move in rates.”
– Johan Jooste, Chief Investment Officer, Bank of Singapore, Member of OCBC Wealth Panel
In 1H 2018, a toxic cocktail of higher interest rates, tighter liquidity, a strong US Dollar, rising oil prices and ongoing global trade tensions dominated the narrative. While we do not expect all of these headwinds to disappear, rate increases may be more measured and predictable. This factor, coupled with still adequate top-down economic growth, solid bottoms-up financials and more attractive valuations, means that bond markets can still offer investment opportunities.
Fed expected to raise rates further
The Fed’s policy intentions are sufficiently transparent that the seventh rate-hike of the current cycle and a slightly more hawkish tilt in the outlook was met with minimal financial market reaction. We continue to expect two more hikes this year and another four in 2019, as the Fed struggles to contain inflation close to the 2 per cent target. It will eventually need to push rates past neutral levels of 2.5 to 3 per cent to cool down growth. Also, markets expectations for the path of US policy rates looks too low.
US Treasuries seem to be more interested in the potential impact of trade friction on growth (and on demand for safe-haven assets), rather than Fed policy changes. Similarly, yields have shrugged off the lowest US unemployment rate in 50 years and the probability of a strong bounce in 2Q GDP growth.
The likely reaction of the Fed – or other affected central banks – to rising tariff barriers is unclear. If the situation escalates then it will both hurt growth and boost inflation. This is perhaps like the dilemma facing the Bank of England due to Brexit, where tightening has been slow and hesitant despite a lengthy inflation overshoot.
Yield curve inversion and rising bond yields
Yield curve inversion remains a popular topic for discussion but does not seem likely until sometime after policy becomes restrictive, which is probably not until 2020. We expect longer-dated yields to head higher as the Fed tightens, and generate poor returns on investment grade bonds, so we remain underweight. On our forecast, 10-year US bond yields are projected to rise to 3.4 per cent in the next 12 months.
Yield gap should also limit upside of US Treasury yields
A significant gap has developed between US bond yields and those in major developed markets. With other central banks well behind the Fed in their tightening cycles, US yields should generate some “carry trade” flows that will help to fund the growing trade and budget deficits and prevent longer dated US bond yields from rising too sharply. US 10-year Treasuries offer a substantial premium over the 0.4 per cent yields in Germany and zero in Japan. Even Italian yields are below the US, at 2.7 per cent, despite high-profile concerns about the willingness of the new government to maintain fiscal discipline.
Preference for High Yield over Investment Grade
During the first half of the year, Investment Grade bonds outperformed High Yield bonds. In 2H 2018, High Yield bonds, buoyed by improving company balance sheets and historically low default rates, could reverse the trend and outperform Investment Grade bonds.
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