As global bond markets move into 2019, the pace of interest rate hikes appears to be moderating as central bank officials struggle to read the tea leaves on economic growth.
Mixed signals on the pace of growth – as well as trade tensions between the U.S. and China, uncertainties about Brexit and the fallout from the U.S. government shutdown – present challenges that bond fund portfolio managers need to assess continuously in order to be able to adapt their portfolios quickly.
Rates moved upward steadily throughout 2018 in both the U.S. and Canada. The U.S.’s key interest rate is in the 2.25%-2.50% range, the highest level since 2008, after four hikes last year. However, the U.S. Federal Reserve Board has signalled it will be less aggressive this year, with the number of rate hikes widely expected to be two.
In Canada, the benchmark short-term rate now stands at 1.75% after the Bank of Canada decided not to raise rates in early January. Meanwhile, the bellwether U.S. 10-year treasury yield has dropped from a seven-year high of 3.24% in the autumn of 2018 to 2.7% in mid-January, indicating that long-term rates also may have peaked for the time being.
Financial markets demonstrated a strong negative reaction to the Fed’s most recent rate hike, in December 2018, and investor nervousness was aggravated by statistics indicating a slowdown in U.S. manufacturing. In addition, Apple Inc. cut its forecast for revenue growth, fuelling concerns that trade tension with China may be taking a toll.
While the pace of U.S. manufacturing new orders has declined, and housing and auto sales have been slowing, the employment picture in the world’s biggest economy remains healthy. The U.S. added 312,000 jobs in December, well above expectations and the biggest monthly gain since February 2018. Unemployment hovers at a low level of 3.9%, and wages have been rising.
From a global perspective, Japan’s economy is contracting and the pace of China’s is slowing, given a recent drop in factory output, falling auto and retail sales, and a heavily indebted middle class.
In Europe, the pace of economic recovery has been sluggish for several years, and France and Italy have been suffering political turmoil recently. The European Central Bank is likely to continue to avoid raising rates.
While bond fund portfolio managers foresee slowing in the pace of rate hikes in the U.S. and Canada, they nevertheless continue to view the interest rate environment as one in which the next move is most likely upward. Portfolio managers’ risk minimization strategies typically involve a preference for higher-quality bonds.
With corporate bonds, higher yields are the reward for taking on more risk, and portfolio managers are determining which industries are most vulnerable to an economic slowdown and thus are being highly selective in choosing debt issuers.
“We are operating under the assumption that 2% is a reasonable assumption for inflation, which implies real [economic] growth of about 1% for the U.S.,” says Soo Boo Cheah, senior portfolio manager with RBC Global Asset Management (U.K.) Ltd. in London, and co-manager of the $7.7-billion RBC Global Bond Fund.
With the yield curve flattening in the U.S. as the spread between short-term and long-term yields has narrowed, Cheah’s strategy for the U.S. component of the RBC fund’s portfolio has been to increase the weighting of longer maturities at the expense of short-term bonds.
Regarding European bonds, for which the yield curve is steeper, Cheah has done the opposite, focusing on shorter-term maturities.
The net result is that the RBC fund’s duration is roughly neutral relative to its benchmark, the FTSE world government bond index (Canadian dollar-hedged).
In terms of geographical allocation, the RBC fund recently had 5.4% of assets under management (AUM) held in emerging markets bonds, with about 62% held in other international markets, 31% held in the U.S. and almost 2% held in Canada.
Cheah reduced holdings in German bonds as prices rose in late 2018 and they became expensive, and “recycled” the proceeds into U.S. treasuries. He also did some trading in Italian bonds, buying as prices fell and yields rose due to political disruption last autumn; later, he reduced that exposure when the market calmed down.
To reduce volatility in the RBC fund, Cheah is adding holdings in stable government bonds, which currently make up almost 90% of AUM.
“Risk management is what we do to generate alpha,” Cheah says. “Our clients view the fund as a core holding, and they want low volatility and steady cash flow. Government bonds tend to do well during turbulent times.”
A sell-off in corporate bonds during the financial market turbulence in late 2018 created some opportunities to pick up bargains, Cheah says, but the key is a “rigorous selection process” with a wary eye on default risk.
Says Cheah: “By no means are corporate bonds a screaming ‘buy.’ But some are becoming interesting.”
Over the past two and a half years, the RBC fund’s exposure to emerging-market bonds has been reduced to almost 5% from 15%. Cheah says the strategy has been to “peel off” risk in emerging markets by reducing exposure to bonds issued in local currencies.
“In emerging markets, we are focusing on sovereign bonds priced in U.S. dollars,” Cheah says. “It’s a diversified strategy with a defensive bias. You don’t get paid as much with sovereigns, but they’re more solid.”
Jean Charbonneau, senior vice president, portfolio manager and head of the fixed-income team at AGF Investments Inc. in Toronto says investors who diversified their balanced portfolios with some bond exposure in 2018 preserved their capital on the fixed-income side as equities markets dropped. AGF Global Bond Fund, which he oversees as lead manager, finished 2018 virtually flat in a year during which North American interest rates rose.
Looking ahead, Charbonneau anticipates a respite in short-term rate hikes, and says the U.S. 10-year treasury rate probably saw it’s recent peak last autumn.
“The probabilities of a recession have risen,” Charbonneau says, “but we are not currently of a recession mindset.” More likely, the U.S. economy will grow at a nominal rate closer to 2.5% this year, he says, and any recession could be a year or two away.
“The U.S. Fed is taking a less aggressive, more cautious approach to tightening, and there will be fewer rate hikes in 2019 than previously anticipated,” Charbonneau says. “[This] is a good time to rebalance toward the bond market, as valuations are in a good place.”
For example, Charbonneau says, there has been upward pressure on spreads between high-yield and safer bonds. Some corporate issues have been under price pressure with the economic outlook looking less rosy, and opportunities are appearing. However, he says, the AGF fund still is on the low side of its normal range for high-yield exposure and is slightly underweighted in investment-grade corporates, which together account for about 16.5% of AUM.
“If we’re not going into a recession,” Charbonneau says, “and there is no increase in the default rate, high-yield bonds could be attractive, and it could be a bit of a ‘Goldilocks’ scenario. However, we are not yet getting aggressive, and may see a further widening of spreads.”
The AGF fund is active in a variety of fixed-Income categories, including high-yield and investment-grade corporate issues, real-return bonds, convertible bonds and emerging-market bonds. The team has been trimming inflation-linked, real-return bonds in recent months as pressure on rising interest rates has eased with a relatively benign inflation outlook.
With interest rates levelling off, Charbonneau says, there is an opportunity to add some duration to the AGF fund. Duration in 2018 was slightly lower than the benchmark index to reduce exposure to rising rates.
On a geographical basis, the AGF fund is underweighted in Europe and Japan, and significantly overweighted in Canada.
“Italy has been a bit of a headwind for the eurozone with its populist coalition government,” Charbonneau says. “The soap opera isn’t over in Europe.”
The AGF fund has a relatively high exposure in emerging markets – equal to about 10% of AUM – primarily in local currencies and including small positions in non-investment-grade securities in such markets as Brazil, Argentina and Peru. Currency trading opportunities are part of Charbonneau’s strategy to augment returns.
“There has been a downward repricing of emerging markets fixed-income securities in the past year or so,” Charbonneau says. “Valuations are attractive now, and we could also see some alpha from local currencies. If U.S. growth is slowing and converging with world growth, the U.S. dollar may have peaked.”