By Manpreet Gill
About USD 13 trillion worth of bonds in the global marketplace now offer a negative yield. Perhaps most starkly, a rising number of riskier, so-called ‘high yield’ (or ‘junk’) bonds in Europe are offering a negative yield. Understandably, many investors question why they would lend to an entity, and assume credit risk, knowing they will get back less money tomorrow than they have today.
Even if an investor does not invest in bonds carrying a negative yield, the phenomenon begs the question: how does one generate a regular income in a world with falling bond yields? For – let’s lay it out upfront – a major rebound in bond yields is unlikely for the next few quarters, in our view, given expectations of subdued growth and inflation and increasing chances of rate cuts by central banks worldwide.
Against this backdrop of declining bond yields, the ‘search for yield’ is likely to remain in place for an extended period of time.
Being choosy about risk
For bond investors, this raises some potentially uncomfortable questions. Let’s take the case of USD-based investors looking to earn a regular income. The sharp decline in yields on US government bonds (considered one of the safest worldwide) this year means they will need to consider whether it is worth taking on additional risks in order to maintain a specific nominal level of yield, or simply reduce yield expectations in line with those of the market. There is, after all, no free lunch!
We are not averse to adding risk in specific situations. However, it is important to consider what kind of risk is worth adding:
- One could add longer maturity bonds, which typically carry higher yields. However, in today’s world where the gap in yields between short- and long-maturity bonds is small, this risk does not appear to be very rewarding.
- One could add credit risk. In other words, add bonds of riskier companies or governments in order to earn higher yields. Within reason, we believe this strategy can be rewarding (as we describe later, we see value in Emerging Market USD-denominated government bonds). However, the strategy does require one to tread carefully. Adding excessive amounts of very low-quality corporate bonds, for instance, may not work out well in the current late stage of the economic cycle.
- One could take on currency risk, usually by adding bonds denominated in currencies other than one’s base currency. This strategy could also make sense should the USD weaken over the coming months, as we expect. However, we are mindful that FX exposure can add a lot of volatility to a bond allocation. Hence, we believe it is worth treading cautiously and waiting for a USD weakening trend to establish itself before considering adding this risk.
EM USD government bonds preferred
Given this, the asset class within USD-denominated bonds that we find most attractive are Emerging Market USD-denominated government bonds:
- The asset class still offers attractive value, in our assessment. Yield premiums over benchmark US government bonds are still not too tight, unlike many risker corporate bond markets which appear increasingly expensive.
- The asset class is well diversified, with no one country’s bonds making up a significant part of the universe
- There is admittedly heightened sensitivity to changes in US government bond (Treasury) yields. However, this is a risk we are comfortable taking, given the relatively high absolute yield on offer, and our view that Treasury yields are unlikely to rebound strongly in the coming months.
The bond asset class ranking second in our preference order are Asian USD-denominated corporate bonds. While the absolute yield on offer is not as exciting as on Emerging Market USD bonds, the relatively low volatility of this type of bonds per unit of yield is very attractive, in our view. These bonds have historically been supported by sustainably strong regional demand from a loyal Asian investor base (from investors looking for USD-denominated assets).
Search for yield, but mind the landmines
We have been here before – low and falling government bonds yields can trigger a rush to add risk in order to lock in a relatively higher level of yield. This is not bad in itself – as investors, we are ultimately paid a return in order for taking on a risk. However, not all risks are the same and some inevitably can turn out to be landmines, especially if the economic cycle comes to an end. In the ongoing search for yield, we see specific types of bonds – Emerging Market USD government bonds and, to a lesser extent, Asia USD bonds – as offering risks that are worth taking on today to earn an attractive regular income, especially as part of a broader diversified investment allocation.
(Manpreet Gill is Head of Fixed Income, Currency and Commodity Strategy at Standard Charted Bank)