Our fund managers in government, corporate and emerging market bonds look at potential drivers of bond markets in 2019.
2 minute read
Bonds have endured a difficult year in 2018 with markets having taken their cue from a relentless rise in US Treasury yields. Emerging debt markets were especially weak, troubled additionally by a rising US dollar and worries over the economic fallout from a worsening trade war between the US and China.
Looking ahead to 2019, government bond prices look likely to continue to fall, with the long end of yield curves under most threat as term-premia return, with ‘peripheral’ European markets especially vulnerable. Credit markets also look to be in for another tough year, although cheap valuations mean emerging debt markets could find support.
Here are five trends that could shape bond markets in 2019.
Tighter monetary and looser fiscal policy
With the need for emergency stimulus having long since passed, and as central banks’ confidence that inflation is returning grows, quantitative easing will be wound back and replaced by ‘quantitative tightening’ – a concerted effort by central banks to tighten monetary policy, either by raising rates, scaling back bond purchases or a combination of the two.
The US Federal Reserve has started, the European Central Bank (ECB) is stopping its bond purchases and even the Bank of Japan is adjusting its response. This is bad news for bonds, especially the long end of yield curves. Worse still, this is happening at a time when several countries have begun to loosen fiscal policy. The fact one of the main sources of demand for bonds is disappearing at the precise moment several governments are looking to expand their deficits is troubling.
With central banks stepping back at the same time as governments are starting to supply more bonds, sovereign bond risk will have to be re-priced. The likelihood is that yield curves will steepen. Within Europe, the Italian market looks especially fragile, with Rome on a collision course with the EU over its 2019 budget. That suggests other peripheral euro zone markets could also be vulnerable, especially with the ECB now curtailing bond purchases and set to raise rates in 2019.
Wider corporate bond spreads
Corporate bond markets are likely to come under continued pressure in 2019. Many companies are now facing significant pressure to reduce their debt load after years of overextending their balance sheets to fund acquisitions and share buybacks. Spreads over government bonds look set to widen, pushing up corporate interest costs.
In Europe, many investors have yet to fully grasp that the ECB, which now owns as much as 30 per cent of the European investment-grade market, is set to begin to unwind its asset-purchase programme next year. The impact that could have on the market could be bigger than anticipated.
Mounting pressure to get debt under control
Drilling down into individual companies’ financial positions will be more important than ever. That is largely because non-financial corporations have issued record amounts of debt in recent years. With interest rates rising, many of these companies are struggling to get debt under control.
The credit quality of many companies rated A and BBB has already deteriorated. Until recently, rating agencies had given them the benefit of the doubt but that is also starting to change. Whereas investors were happy to snap up debt in a world fuelled by QE, downgrades and falling bond prices should be expected for the most vulnerable companies as rates continue to climb.
Emerging market debt could rebound
Emerging market debt yields are again starting to look attractive, although investors need to be extremely selective. For example, the real yield spread between the South Africa component of the JPMorgan GBI-EM index and ten-year US Treasuries was 437 basis points on 30 November, compared to its ten-year monthly average of 271 basis points. For Indonesia, that spread was 438 basis points versus its ten-year average of 301 basis points, while the spread for Mexico was 509 basis points versus an historical average of 292 basis points.
Bonds issued by banks look relatively attractive
Bank debt seems poised to outperform other parts of the corporate bond market, especially at the shorter end of the curve. Lenders have greatly strengthened their balanced sheets since the financial crisis, partly by raising capital, whereas non-financial corporations’ balance sheets have veered in the opposite direction. The fact that the market is heavily regulated should also comfort investors.