In line with expectations, the US Federal Reserve (FED) raised its short-term rates by a further 25 basis points this week. This was the fourth interest rate hike this year and the ninth since December 2015.
Despite the pressures from Trump for the FED not to raise rates, the central bank still moved ahead, confirming the strength of the US economy. However, US growth is expected to slow down and, as a result, the FED hinted that interest rate increases will be fewer next year. Following these comments the yield on the 10-year US Treasury headed even lower (price increased).
It is hardly surprising that the past 12 months have been so volatile for both equities and fixed income. Following the last financial crisis, central banks had various tools to deploy in order to help economies emerge from the financial mess the world economy was in. The accommodative monetary policy adopted throughout the period was imperative to lift confidence. These measures stifled volatility and in turn made investors’ life much easier. In fact, many investors say a great portion of the past decade had been a sea of calm for most asset classes.
This no longer holds, as during 2018, market volatility returned across global markets and asset classes. Political tensions and increasing interest rates (tighter monetary policy) weighed heavily on corporate bonds’ performance. As a result, demand for bonds declined. Even though this might persist going in 2019 we believe that slower growth is supportive for certain segments within the bond market.
So what does 2019 hold for bond investors? We believe that markets will remain volatile going forward as political tensions remain and different economies are at different stages of the economic cycle. However, the repricing witnessed in global fixed income assets during the past year will definitely create opportunities for bond investors going forward.
High quality sovereign bonds have already seen some noteworthy moves in recent weeks on expectations of lower global growth. The yield on the 10-year US Treasury moved to 2.77 per cent from 3.23 per cent a month ago. In Europe, the same maturity German bund moved from 0.46 per cent to 0.24 per cent over the same period. In 2019 these shifts may suppress yields across high-quality investments.
Credit markets, which include investment grade and high-yield bonds among others, had a challenging year and those challenges will most likely remain next year. Default rates remain at historically low levels and data suggests that fundamentals across investment grade and high yield are healthy. This is supported by a strong US economy and improving economic data in Europe.
In terms of investment grade bonds, yields are at levels not seen since mid-2012
Investors should keep in mind that generally high-yield bonds have shorter durations than other types of bonds and so are less sensitive to interest rate changes. In addition, high-yield issuers are usually domestic rather than global and hence less exposed to trade concerns. Yet, we should keep in mind that the price of high-yield bonds is highly correlated to equity markets, and hence if equities are volatile going into 2019, we might see volatility across high-yield bonds too.
As we highlighted earlier this year through one of our weekly articles, going forward bond investors should choose active over passive strategies. In terms of high yield bonds, an active strategy can help investors to shy away from cash strapped bond issuers. As the US nears the end of the economic cycle and liquidity across financial markets decline, we might witness higher default rates. More importantly, investors should avoid investing in those direct high yield bonds which are trading at abnormal yields.
In terms of investment grade bonds, yields are at levels not seen since mid-2012. In addition some high quality bonds are providing investors with decent income returns without having to opt for long-dated bonds. Investors who in the past years have moved down the quality ladder seeking higher returns, can now start looking to improve the quality of their bond portfolio. That is, decent yields exist at much lower risks.
In November we had the opportunity to meet some bond fund managers in London. One common view shared by most is the expectation of slower economic growth in the coming years. With economic growth expected to slow down and inflation rates under control, we believe that bond investors can find value across various fixed income assets.
Based on this, we see scope for investors to invest in fixed income next year. Pessimism will impact bond prices and some might be affected more heavily. Hence the need for a diversified bond portfolio. Expectations of lower US growth will induce the FED to slow down its monetary tightening programme. If this is the case and rates peak at around the three per cent level, investors have another reason why not to shy away from global bonds. We are mindful of the fact that rates might go further higher and that may dampen the outlook for bonds. However, with inflation expectations subdued, we expect 2019 to be a better year for most bond investors.
This article was prepared by Gabriel Mansueto, branch manager and senior investment adviser at Jesmond Mizzi Financial Advisors Ltd. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company and their clients, are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For more information, contact Jesmond Mizzi Financial Advisors Ltd of 67, Level 3, South Street, Valletta, on tel. 2122 4410, or e-mail gabriel.mansueto@jesmondmizzi.com.
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