australieen
Fixed Income Quarterly Outlook: yield drought & bond scarcity

Fixed Income Quarterly Outlook: yield drought & bond scarcity

19-07-2016 | Insight

The world economy is marked by sluggish growth and absent price pressure. Despite unprecedented monetary easing, inflation expectations have declined further. Bond yields have set new historical lows and can continue to do so. Central bank buying programs add to the picture as bond scarcity in core government markets increases downward pressure on interest rates.

  • Stephan  van IJzendoorn
    Stephan
    van IJzendoorn
    Senior portfolio manager Global Fixed Income Macro
  • Paul  van der Worp
    Paul
    van der Worp
    Portfolio Manager Fixed Income

Speed read

  • As prospects for further rate cuts are slim, we prefer long-dated bonds
  • We are cautious on credit and favor Europe, specifically subordinate financials
  • This year’s star performer emerging local debt has further to go

In the Eurozone, the rules of the ECB’s Quantitative Easing (QE) program are forcing the ECB to buy long-end bonds only. The deposit rate rule only allows the ECB to buy bonds with a yield to maturity higher than the deposit rate, i.e. minus 0,4%. With declining interest rates, more and more bonds trade below the deposit rate, making them ineligible for the ECB to purchase.

In practice it means that since the start of June, the minimum maturity that can be bought moved from 5 to 8 years in Germany. This also has a second round effect: with a decreasing pool of purchasable bonds more needs to be bought per bond to get to the required monthly target of EUR 80 billion. As a result, one of the other rules of the program becomes increasingly pressing: the maximum percentage that may be purchased per outstanding bond. This limit, also known as the issue limit, is set at 33%.

Without changes in the parameters of the purchase programs, we think that the ECB will struggle to buy government bonds in both Germany and the Netherlands around year end. The ECB has options to increase the issue limit for bonds issued before 2013 to e.g. 50% or more. This will give the ECB leeway to continue buying for one or two more quarters. And since these older bonds are mostly concentrated in the long end of the curve, the ECB will again focus buying in that part of the curve.

An alternative ‘nuclear’ option to address the scarcity issue is for the ECB to give up on the capital key rule. Currently the government bond purchases are split across the Eurozone countries according to the capital key weights. The key is calculated according to the size of a member state in relation to the European Union as a whole, size being measured by population and gross domestic product in equal parts. Changing the purchasing basket according to e.g. debt outstanding (market capitalization) would hugely favor Italian bonds at the expense of German bonds. Italy’s outstanding public debt is higher in nominal terms whereas the economy is smaller. We regard this option as politically highly controversial for now. It would be a step closer to Eurobonds. However, in the context of an existential threat to the euro system (Brexit, meltdown Italian banking sector) nothing can be excluded.

Stay informed on Credit investing with monthly mail updates
Stay informed on Credit investing with monthly mail updates
Subscribe

Preference for long dated bonds in US and Eurozone

As prospects for (further) rate cuts in the US and the Eurozone are slim, long dated bonds remain our favorite. In the US the 30-year yield is approaching the 2% handle. The US money market curve no longer discounts any rate hike for the next two years. From a risk/reward perspective, most value is in long dated US Treasuries. In the Eurozone we expect the 30-year segment in Germany to benefit from further ECB policy measures, as explained above.

Brexit favors UK Gilts

The surprise outcome of the Brexit referendum is bullish for UK Gilts. Business and consumer confidence in the UK will tumble. The Bank of England may potentially restart Quantitative Easing. The UK Gilt market will converge to the Eurozone bond market dynamics, having shown more parallels with the US Treasury market in recent years.

Selective in credits: focus on Europe and subordinated financials

As the credit cycle is maturing, leverage is rising, especially for US companies. This calls for a cautious stance. We favor the European corporate bond market, more specifically subordinate financials. Brexit fears and worries about the Italian banking sector have pressured this segment year to date. We believe current valuations offer enough protection. The ECB corporate bond purchasing program will have positive spill-over effects also for this specific sector.

Constructive on emerging local debt

The star performer of the year has further to go. The imminent threat of a Fed rate hike has disappeared for now. This enables investors to focus more on the attractive yield differential compared with developed markets. Fund flow information underlines that appetite for this battered sector is gradually coming back.

Leave your details and download the report.

This report is not available for users from countries where the offering of foreign financial services is not permitted, such as US citizens and residents.

Disclaimer:

I agree to the Robeco Disclaimer and the collection and use of my personal data by Robeco, for the purposes for which such data is collected and used as set out in the Privacy Policy, including for the purpose of direct marketing of Robeco products or services. Your data will be treated with utmost care and will not be passed on to third parties.

Disclaimer

BY CLICKING ON “I AGREE”, I DECLARE I AM A WHOLESALE CLIENT AS DEFINED IN THE CORPORATIONS ACT 2001.

What is a Wholesale Client?
A person or entity is a “wholesale client” if they satisfy the requirements of section 761G of the Corporations Act.
This commonly includes a person or entity:

  • who holds an Australian Financial Services License
  • who has or controls at least $10 million (and may include funds held by an associate or under a trust that the person manages)
  • that is a body regulated by APRA other than a trustee of:
    (i) a superannuation fund;
    (ii) an approved deposit fund;
    (iii) a pooled superannuation trust; or
    (iv) a public sector superannuation scheme.
    within the meaning of the Superannuation Industry (Supervision) Act 1993
  • that is a body registered under the Financial Corporations Act 1974.
  • that is a trustee of:
    (i) a superannuation fund; or
    (ii) an approved deposit fund; or
    (iii) a pooled superannuation trust; or
    (iv) a public sector superannuation scheme
    within the meaning of the Superannuation Industry (Supervision) Act 1993 and the fund, trust or scheme has net assets of at least $10 million.
  • that is a listed entity or a related body corporate of a listed entity
  • that is an exempt public authority
  • that is a body corporate, or an unincorporated body, that:
    (i) carries on a business of investment in financial products, interests in land or other investments; and
    (ii) for those purposes, invests funds received (directly or indirectly) following an offer or invitation to the public, within the meaning of section 82 of the Corporations Act 2001, the terms of which provided for the funds subscribed to be invested for those purposes.
  • that is a foreign entity which, if established or incorporated in Australia, would be covered by one of the preceding paragraphs.
I Disagree