Are Fixed Income Markets Overvalued?
A comment we regularly hear from our clients, whether in individual meetings or at investor events, is that “bonds are expensive.” This, of course, is a fair point but is at odds with our current thinking. The reality is that in today’s world, there are no “cheap assets” and those that are, are cheap for good reasons.
In our view it is no longer possible to argue that bonds are cheap. Instead, we believe they are probably at or around fair value and reflect the current market environment in which we have low volatility, low defaults, low inflation and a reasonable level of global growth.
Owners of bonds get their returns from two places: income and price movements. In light of current valuations, where spreads have tightened significantly post the Global Financial Crisis, we think that future bond returns will mostly come from the “income” element. This is an environment in which a carry strategy (i.e., collecting the coupon) still works, because there are many bonds with reasonable levels of coupon to ensure a good income stream.
Exhibit 1 shows the typical returns from various fixed income assets and equities over selected periods.
Exhibit 1: Historical Total Returns for Fixed Income and Equities
Enough Bonds in Investors’ Portfolios?
Another question we receive is whether we believe bonds are “under-owned”? It is clear that equities have attracted significant inflows and investors are feeling quite euphoric, typical late cycle characteristics. Equally, as Exhibit 1 shows, fixed income asset classes have performed well on a 10-year view.
We would not argue that either asset class is cheap, but we do believe that investors who seek diversification can potentially do so by holding an appropriate level of bonds. Bonds, and particularly higher quality ones, tend to do well if equities sell off and so can provide investors with that diversification. To illustrate this, while the S&P 500 Index was down 38% in 2008 at the height of the crisis, the U.S. investment-grade (high quality) corporate bond index returned -7.9% and U.S. 10-year Treasury 17%.
We think a lot of investors are currently focusing on where things can go wrong for bonds. The asset class has enjoyed a particularly strong run, with yields on U.S. Treasurys reaching a July 2016 low of 1.36% (lower yields mean higher prices), although they have since climbed by more than 1% from this low point*.
Rate Rises – What Will the Impact Be?
Investors also question whether the fact that the U.S. economy is doing well, and Federal Reserve officials are suggesting more rate hikes are likely in the near future, mean that bonds are no longer a worthwhile investment. We believe that they still are, and mainly because rate rises are likely to be measured.
The economy, while growing, is expanding far less quickly than historical norms, and inflation is also well anchored. We have long thought that Japan provided interesting parallels for other developed markets, given its aging population and recovery from a debt-fueled crisis.
Based on the experience of Japan, we think that while we will see interest rates increasing, the rises are likely to be measured and provide only a small headwind, which coupons should be able to more than offset. Also if bond yields rise, investors will be able to reinvest maturing bonds into more attractive ones with higher yields, which in time could boost returns.
Outlook and Valuations
Exhibit 2 below is a comparison of the yields on various fixed income asset classes. Based on this, we do see reasonable value in investment grade, particularly within BBB-rated bonds in the U.S, while within high yield we still think that there is room for further compression in yields in the U.S.
Exhibit 2: Current Yields Across Global Fixed Income Markets
The theme we expect to play out in 2018 is that the global economy will continue to do well. Defaults will likely continue to be low, which favors higher yielding credit on a relative basis. The key will be to continue to be selective and remain disciplined with late-cycle conditions evident in the level of dispersion between sectors. This is magnified by significant technological and industry changes impacting certain industries and sectors.
The extent of current levels of dispersion in valuations within high yield and investment grade are shown in Exhibits 3 and 4 below. The charts reveal a much higher level of dispersion within high yield but less so for investment grade given its higher quality (e.g., lower levels of leverage).
To illustrate, high-yield corporate bond spreads in sectors with percentile ranking of 50 and above, are now wider than their historical average spread (the period from 2000 to present), which is indicative of sector issues, but 13 of the 20 sectors are trading in the bottom quartile (tighter spreads than their historical average).
We expect high-yield dispersion to remain elevated, and this should benefit opportunities for credit picking.
Chart 3: High Yield Bond Valuations - Ranking by Sectors
Exhibit 4: Investment-Grade Bond Valuations - Ranking by Sectors
An additional point to note is that we have seen money flowing into alternatives, with investors chasing returns. These alternatives are often complex investment structures promising higher returns to compensate for the lower liquidity available versus traditional fixed income instruments. A lot of these strategies are unproven and the depth of liquidity in these markets is quite shallow.
The questions we are currently being asked by investors are very valid. At a valuation level, while many high-quality credits are trading at fairly expensive levels, in our view they are justifiable when taking into account a macroeconomic outlook and the quality of the issuers.
In summary, we believe that the value proposition for investing in fixed income assets remains intact.
*10-year U.S. Treasurys yield around 2.3%, as of November 6, 2017.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.