09 Oct FORSTRONG: BONDS: Too Much Negativity?
GLOBAL STRATEGY OVERVIEW
CASH
With longer-term global bonds looking increasingly vulnerable, we have modestly raised portfolio cash levels to offset equity risk and dampen volatility.
BONDS
The path of least resistance for short-term bond yields should be lower, as accommodative central bank policy worldwide should suppress upwards pressure. Against this backdrop, short-term fixed-rate debt should outperform floating-rate notes. We have sold Canadian and US investment-grade floaters and redirected the proceeds into short-term corporate bonds.
EQUITIES
The vast majority of countries now have a higher dividend yield than 10-year sovereign bond yield. Ironically, equities have become the predominant source of portfolio income. We continue to tilt client portfolios further towards equities, which in addition to their superior yield, better align with our view of a return to slow, stable global growth.
OPPORTUNITIES
A steepening US yield curve would be a favourable environment for US mortgage REITs, allowing for a larger spread between short-term borrowing costs and long-term mortgage investment portfolios. With a dividend yield currently over 10%, we have added exposure to the asset class to boost income and position for a reversal in long-dated bond yields.
BONDS: TOO MUCH NEGATIVITY?
Bonds play a vital role in portfolio construction. Allocations to high-quality debt provide a stable source of income, decrease volatility and broaden exposure to additional factors which drive returns. This ultimately creates a more resilient portfolio. For this reason, even Forstrong’s most equity-oriented strategies, designed to have higher growth potential, will still maintain some fixed income exposure.
With that gushing preamble out of the way, our view on bonds (and for that matter all other asset classes) fluctuates over time. Generally speaking, fixed income assets tend to be most attractive in times of steady or weakening growth, where longer-term yields are stable or falling. This has certainly been the case of late, as a struggling global manufacturing sector has put a dampener on the world economy. So we should all be loading up on bonds…right?
We would caution against jumping on the bond bandwagon. Before even considering the economic outlook (we’ll get there), the debt market is showing signs of extremes. Consider that bond funds have seen record inflows this year and are a consensus overweight amongst global fund managers. Long-term bond yields have rapidly collapsed, leading to inverted yield curves in numerous economies. Per the chart below, approximately 15 trillion USD in investment-grade global issuance now carries a negative yield. Bond bulls are effectively betting that the asset class marches further into subterranean territory.
The deceleration in global growth warranted a fall in bond yields, but it is critical to look at the magnitude of the move and delineate what the current price is telling us about the market’s expectations. Moves in the widely tracked 10 year US treasury and German bund provide a helpful illustration, having fallen significantly (approximately 175 and 120 basis points respectively) from their highs in the fourth quarter of 2018. Currently, near the 1.5% level, the US 10 year has a negative real yield, while its German counterpart incredibly has a negative nominal yield near -0.6%. These are clearly not prices that concur with Forstrong’s expectation that bottoming leading indicators, dovish central bank policy and the prospect of meaningful fiscal stimulus foreshadow an impending economic stabilization.
Is the bond market a bubble? Not by the classic definition, but there is definitely a bubble in fear. Investors are charging every notorious corner of global debt markets. Nevermind the swelling amounts sunk into negative-yielding debt. Stand in wonder of the more freakish fixed-income issues. For example, the Republic of Austria recently brought back its “century bond” — riddled with interest rate risk — at a whopping 1.2%. Regardless, bond exposure still serves an important diversifying role in portfolios; the current environment just necessitates a greater degree of selectivity. We prefer exposures such as emerging market sovereign bonds which have positive real yields, upside currency potential and a credit element that would benefit from firming global growth.