Willem Sels, HSBC Private Bank’s UK Head of Investment Strategy on why he thinks cash and safe haven bonds are the most expensive assets to hold…
The outlook for risky assets remains uncertain, but holding cash is bound to generate a very low return in developed markets. Similarly, safe haven government bond yields are near or at historical lows (low income) and arebound to rise (generating potential losses), even if we expect this process tobe gradual. Given the very high likelihood of low returns in cash and safe haven bonds, we look for alternatives where we can pick up yield. However, we remain selective, with our investment choices driven by our view that:
1) global economic growth remains below the historical average,
2) European sovereign risks are unlikely to disappear quickly, and
3) global liquidity may push up inflation expectations (hence limiting our duration exposure).
Cash yields are low and are likely to remain low for the foreseeable futures in the UK and the US, while in the Eurozone, they may drop even further if the ECB decides – as we expect – to cut interest rates later this year. While deposit rates vary significantly between banks, depending on their funding needs and credit quality, many banks offer much higher interest rates for somewhat longer dated maturities. In part, this is because they want to secure funding, but it is also because banks need to own low-yielding liquid assets (gilts in the UK) against any deposits shorter than 3 months, while this is not the case for longer-dated funding. Extending deposits from 3 to 12 months can often lead to a tripling of the rate, which can be attractive if the portfolio does not need the immediate liquidity.
The fact that 1-year Italian bonds offer a higher yield than a 10-year gilt (or a 10-year Bund or US Treasury) illustrates just how far the flight to quality has gone. Some of this move may be exaggerated, and we believe that for more aggressive investors, there are buy-and-hold opportunities in short-dated European sovereign bonds. Italy for example pays 2.3% for a one-year bill.
It does not seem necessary (or prudent) to extend duration too far in the Eurozone: the yield pickup for any given country relative to safe haven gilts or Bunds is already very significant for 1- or 2-year maturities, after which the curves are roughly in parallel. Extending duration beyond the 2-year point thus does not add very much to the yield, but can add significantly to the bond’s volatility. The Eurozone periphery is likely to continue to generate many headlines, leading to potentially significant volatility for longer-dated bonds. Therefore, we prefer a buy-and-hold approach, which naturally favours shorter-dated bonds. For the riskier Eurozone countries, or in more defensive portfolios, we limit investments to the bill area, i.e. generally, bonds with an original maturity of 1 year or less. Those bills have traditionally experienced much lower default risk than longer-dated bonds, and bills were excluded from the latest Greek restructuring (i.e. investors got their money back). Moreover, existing bailout plans should provide liquidity to Greece, Portugal and Ireland for the coming year, if conditions are met. Still, even bills are not for the faint-hearted in countries like Portugal and we continue to avoidGreece. Positions in short-dated Italian debt look more main-stream.
We have been buyers of senior bank debt with maturities up to three years following the ECB’s LTRO, as this significantly reduced liquidity (and hence default) risk for Eurozone banks in the short term. Spreads have tightened significantly in past months, even if they have bounced somewhat recently. Bank spreads are now at, or slightly tighter than their sovereign spreads, which is a very rare phenomenon. Therefore, we think any further spread tightening requires sovereign spread tightening. We thus maintain our constructive view on 1-3 year senior bank bonds, but consider them as a buy-and-hold carry play rather tactical trading idea.
Non-financials still look attractive in our view, in spite of past spread tightening. With a 5-year gilt trading at 1.1%, a spread pickup of 2.5% in investment grade can more than triple the yield. Investment grade credit tends to do well in an environment where economic growth is at or slightly below normal, as long as it remains positive. In such an environment, investment spending is low and companies do not feel tempted to lever up. US non-financial leverage, for example, is now near the lowest level in 20 years (with the exception of 2006), while spreads are still higher than at any time in 1999-2008. We maintain investment grade as an overweight in most of our portfolios. However, we limit our duration to 5 years, as we believe that rising longer-dated inflation expectations driven by the global liquidity could hurt bond valuations.
We believe that Chinese economic data continues to point to a soft, rather than a hard landing. As investors look to diversify away from the West’s problems and look for a yield pickup, we think EM bonds have a place in many portfolios.
We have for some time had a preference for hard currency (generally USD) denominated EM debt over local currency debt. As the graph below shows, hard currency debt has significantly outperformed local currency debt, but this may continue and we stick to our preference for USD-denominated debt.
First, inflation pressures are starting to resurface in some emerging market countries, and although this is often linked to commodity or food prices, this may delay any further interest rate cuts that could have supported local currency debt. These inflation pressures, and global uncertainties, have also led to currency volatility, which impacts returns. Finally, EM hard currency fund flows continue to dominate those that go into local currency funds.
High yield probably remains the most volatile sector in the fixed income area, although it has been remarkably resilient to sovereign volatility and global concerns. This is because companies have been carefully extending funding, conserved cash and limited investment spending, and hence kept defaults relatively rare. Rating agencies expect the default rate to remain low, ending the year at 3%. Therefore, we believe that high yield spreads will mainlyremain a function of equity volatility and sovereign tail risk rather than default fundamentals.
European high yield clearly offers a higher yield than US high yield, but this is largely because of poorer economic growth fundamentals and the presence of subordinated and perpetual bank debt in the European index. We continue to hold a preference for US HY over European HY.
Plenty of other yield enhancement opportunities exist in the form of structured products (structured notes or dual currency deposits), which can be tailored to the risk appetite, maturity, liquidity and market view that are appropriate in any given portfolio. In equity portfolios, high dividend strategies using quality stocks can help boost the income, and buffer the volatility if the stock selection is defensive. Of course, the risk profile of this strategy is straying further away from fixed income and high dividend strategies are subject to equity volatility.
Few investors expect any material returns from cash or safe haven bonds, but many are still overweight. While this is understandable given the many uncertainties that remain to the global outlook, we believe that there are many ways to improve the return potential without taking excessive risk. Being out of the market has an opportunity cost which is often underestimated. Short-dated cash in our view is one of the most expensive assets to hold.