In the current environment of low or even negative interest rates – with a surge in inflation linked to the economic recovery on the one hand and supply chain difficulties on the other – it's time to ask whether an investment in bonds has any appeal and how to approach its management? And in this context, what exactly are the alternatives available on the bond markets?
These questions are at the core of the debate in an uncertain environment in which government institutions are playing a critical role in stabilising the economy and the financial markets as well as owning a large share of sovereign debt.
What is the appeal of investment grade sovereign bonds?
Since the central banks’ intervention to address the massive financial crisis, real yields (that means yields adjusted for inflation expectations) have been shunted into negative territory for both the eurozone and the US over a benchmark 10-year maturity. In practical terms, this means that investors wanting to invest over this time horizon are guaranteed to lose money if the effects of inflation are taken into account and their investment is held to maturity. So why are government bonds with negative yields still so popular with a variety of investors? The short answer is that there are few alternatives for investors looking for a liquid investment with no credit risk and a degree of visibility on cash flow. Sovereign bonds issued by AAA-rated countries such as Germany and the US are considered to be risk-free in terms of credit and liquidity. Some institutions such as banks and insurance companies are obliged to invest in these high quality bonds in order to meet the liquidity and credit thresholds imposed on them by regulations. For investors who are not constrained by such institutional requirements, these negative-yield bonds have a certain appeal because they can help to regulate a portfolio’s volatility and protect part of the portfolio in a crisis scenario.
Diversifying a portfolio with sovereign bonds exploits a decorrelation between different financial assets in order to protect the portfolio during times of turbulence. The US Treasury note is a good example and its safe haven status was amply demonstrated when its yield plummeted at the start of the health crisis.
What about risky bond assets?
For bonds with a credit and liquidity risk, such as corporate bonds and those issued by emerging market countries, there is an enormous range within the investment universe and the different categories available allow for diversification in terms of risk and performance. In corporate bonds, for example, several factors contribute to differentiating the risk profile of one issue from another, notably its currency, rating, sector and region. Each of these distinctions accords different dynamics to issues that nevertheless belong to the same asset class. An issue rated high yield [1] will have a higher risk premium than one rated investment grade [2] and, provided there is no issuer default event, this risk premium will help smooth out market movements linked to interest rate changes. The risk premium of an issue is attributed to compensate the creditor for the additional risk incurred compared to an issue with limited risk. This means that a small company with cyclical cash flows will have to pay more on the debt it issues than a large company such as Google or Apple. The same is true for emerging market sovereign issues where the risk premium largely depends on the creditworthiness of the country and its geopolitical risk. The graph below illustrates the performance of different sub-classes of euro-denominated bonds and shows that, although there is a common base for performance determined by risk-free interest rates, there are different degrees of correlation and volatility among the sub-classes.
Performance of various euro-denominated bond indices between January 2016 and December 2021
Source: Bloomberg & JP Morgan; past performance is not indicative of future performance.
Excluding the high-yield index, which had volatility of 7.2%, the volatility of the other indices over the period analysed was around 3.7-3.8%. In terms of the risk/return tradeoff, also known as the Sharpe ratio [3], the JP Morgan Euro EMBI index (emerging market bond index denominated in euros) heads the field over the last six years [4], while the index of AAA-rated government bonds has come in bottom (Sharpe ratio of zero, since there is no excess performance over a risk-free rate). As regards the indices’ correlations with AAA sovereign bonds (Bloomberg Pan-European Aggregate: Treasury Aaa TR index), it is the European High Yield index that deviates the most with a correlation close to 0, while that of the aggregate European Corporate index is 0.8.
Over the last five years, the performance of euro-denominated risk assets has been partly boosted by the decline in default-free sovereign yields. However, in the current economic environment of a tangible return of inflation in developed countries and historically low yields, the short to medium term performance of risk-free sovereign bonds has been adversely affected.
Duration risk (or interest rate risk) therefore comes into play for bonds as a result of the upward pressure exerted by rising sovereign yields. The narrower the yield spread between an issue and the risk-free rate for the same maturity, the more sensitive the issue will be to a rise in the risk-free rate. In this context, it makes sense to look at bonds that offer wider spreads. Accordingly, when risk-free rates rise without affecting the level of the spread, the risk premium offered by the spread will compensate (at least in part) for the loss linked to the rise in yields.
For investors not wanting to increase their overall risk level, when the credit risk of a portfolio is increased, we consider it advisable to take a position on shorter maturities that reduce the duration risk in order to maintain the appropriate level of risk for the portfolio. It may also be useful to combine credit risk and duration risk, for example when the economy is in a reflationary situation (return of growth and inflation) with narrowing spreads on risk assets. Any change in risk profile must be accompanied by a robust credit analysis of the selected high-yield issuer as well as close monitoring of its operational performance. The macroeconomic environment also has an impact on the risk associated with high-yield issuers: when financing conditions become uncertain, high-yield issuers may find they lack liquidity and therefore cannot refinance their debt. Increased volatility in benchmark yields thus leads to widening spreads on risk assets. The graph below illustrates this phenomenon: the volatility of the Germany 5-year mid yield moves in a similar way to the spreads of euro-denominated high-yield issues, while the Germany 5-year treasury yield follows a downward trajectory.
Volatility and Germany 5-year yields against spreads on a high-yield index between 2006 and 2021
Source: JP Morgan
For the time being, the European Central Bank is determined to maintain favourable financing conditions to support the exit from the crisis. In an environment in which inflation is present but controlled, riskier bonds can deliver an attractive risk/return tradeoff despite a rise in long-term yields. However, risk-free sovereign bonds should not be totally excluded from a portfolio since they can be a hedge against systemic credit risk in some cases. In a global portfolio aimed at limiting volatility and maximum loss, a bond segment with some credit risk can help keep these in check in order to ensure a level of return and relative stability of the portfolio's value.
Other sources of return within the bond universe
There are other types of bond issues which provide a return while being decorrelated from risk-free rates. Emerging market or developed country issues denominated in local currencies are a way of taking a position on a currency. Moreover, the coupon offered by the issue partly compensates for any fluctuations in capital linked to changes in the exchange rate. However, it is important to target currencies carefully since the strength of one currency against another depends on various macroeconomic and financial parameters. This relative situation between currencies should be closely monitored as it can vary rapidly with the economic choices made by the countries concerned. Historically, the currencies of emerging market countries have tended to depreciate (or even be devalued). Inflation is generally higher in these countries which, when they are net exporters, seek to remain competitive by maintaining a weak currency. But in the short to medium term, emerging market currencies can be attractive investment opportunities in an economic cycle when, for example, the spread between the policy interest rate of the investment currency and that of the portfolio currency widens. A currency can appreciate as a result of an influx of investments benefiting from an attractive interest rate differential.
This diversification segment can prove very fruitful but is not without risk. Before investing, it is vital to conduct a thorough macroeconomic analysis of the country of the target currency and, given the opportunistic nature of these investments, it is also important to keep monitoring the country's economic situation in order to react quickly to any changes.
Conclusion
Bond assets encompass different categories of investments with a variety of risk and return profiles. The main characteristic of the bond spectrum has historically been low volatility and a higher risk/return profile than other asset classes. For investors seeking to limit capital losses and volatility while their investments are held, the bond market retains a certain appeal. Finally, provided there is no default on the investment, a bond offers the advantage of providing a known return at the time of purchase if held to maturity. It is essential, however, to carry out due diligence on the issue in question.
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[1] Rating below BBB-/Baa3 awarded by a rating agency.
[2] Rating equal to or above BBB-/Baa3 awarded by a rating agency.
[3] The Sharpe ratio of a portfolio or index is calculated as the ratio of the excess return over the risk-free rate divided by the volatility.
[4] Between 01/01/2016 and 31/12/2021.
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Author
Jean-Albert Carnevali, Corporate Fixed Income Analyst, info@bli.lu
The author of this document is employed by BLI - Banque de Luxembourg Investments, a management company authorised by the Commission de Surveillance du Secteur Financier Luxembourg (CSSF).
