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Fixed Income: Return dispersion is the only constant

Fixed Income: Return dispersion is the only constant

20-01-2017 | Perspectives trimestrielles

The variability of fixed income investment returns remains high and this is not likely to change this year. Today’s winners can be tomorrow’s losers and vice versa. An investment approach that has a global universe, is flexible and operates independently from tradional fixed income indices, is best suited to exploit these differences.

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

Speed read

  • Ongoing return dispersion in fixed income requires a global, flexible investment approach
  • Central bank policies and political risks will be key market drivers
  • The credit cycle is maturing, which calls for caution

Return dispersion within the global fixed income markets has been high. Just recall the dismal performance of high yield and emerging local debt over 2015 and compare that with the strong comeback of both categories in 2016. Also within the different segments dispersion in performance is eye-catching. Having ouperformed most other bond markets for four consequetive years, Italian government bonds significantly lagged over 2016. Lackluster growth dynamics and mounting worries on the banking sector made Italian govenement bonds underperform e.g. Spanish government bonds by almost 4%.

Within emerging (local) debt markets, differences were even more pronounced. Double-digit postive returns for markets like Brazil, South Africa and Indonesia contrasted with outright losses for Turkey and Mexico.

‘Central Banks will continue to take center stage in 2017’

Just like in 2016, central banks will continue to take center stage in financial markets. Further policy rate normalization by the Fed seems a given and discussion on gradual balance sheet reduction could follow. In Europe and Japan, the current bond purchase programs will most likely have to be scaled down. With upcoming elections in all major European countries and the new Trump administration getting started, political risk will be another key market driver.

In the midst of all this uncertainty it is striking to see economic developments evolving rather steadily. The global economy can still be categorized by moderate growth and low inflation. Consumer spending is supported by a gradual rise in household income while capex spending and exports are staying behind. US fiscal spending and tax cuts for consumers and corporates will most likely give a short-term boost to US growth, but for other parts of the world the economic recovery will be more gradual. Elevated debt levels, demografic challenges and disappointing productivity growth remain key challenges for advanced economies.

In our investment policy, these are the key themes:

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Stick to the short duration position in the front end of the US yield curve

Rate hike expectations moved up after Fed Chair Yellen had clearly stated that aiming for a ‘high pressure’ economy is not part of the central bank’s script. Adjustments to the Fed’s forecasts were unexpectedly hawkish, both for the near term and the long run. For the coming 24 months, markets now discount four rate hikes in total where the median number of the FOMC prediction equals six. For the coming period we expect markets to move closer to the Fed projections.

Scale back in emerging local debt

We have reduced our exposure to emerging local debt. From a valuation perspective, the asset class still looks appealing, but fundamental and technical considerations are less favorable. Future US trade policy will most likely dampen global trade and unleash protectionism, which does not bode well for economic growth in emerging economies. Additionally, a more aggressive Fed policy accompanied by higher rates and a stronger US dollar will dampen inflows into emerging local debt.

Anticipate further underperformance of Italian government bonds

Robeco Global Total Return Bond fund holds no Italian government bonds and we have even implemented an outright short position via BTP futures. Italian bond spreads have recovered from the widening in November in the run-up to the referendum. New turmoil lies ahead, with either a referendum to repeal the labor market reform or early elections, while fundamentals remain weak.

An extended business cycle supports credits for now

We added some exposure to corporate high yields bonds. The US business cycle will be extended. Corporate profitability will benefit. In the short run, lower taxes and more fiscal spending mean more growth and fewer defaults. However from a medium term perspective, we still believe that the credit cycle is maturing, which calls for caution.

The other credit category we continue to like are subordinated financials. This segment outperformed in the last quarter supported by higher bond yields and steeper curves. These developments are supportive for the profitability of financials. The concerns on the Italian banking sector show that careful issue selection remains key in this sector. We do not hold any Italian banks within our credit portfolio.

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