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Q4 2016 Fixed Interest Review

Wednesday 21st December 2016

Hindsight is a wonderful thing and it would now appear that the first week in July this year saw the all-time closing low on the US Ten Year Treasury. Since that point yields gradually started to increase and after the US Presidential election the rise accelerated combined with a steepening in the yield curve. At the end of the last quarter the yield was 1.59% and we now look set to end the year at close to 2.57%.

There is now a wide divergence in monetary policy between the key central banks, with the Federal Reserve now having raised interest rates twice this year and forecast to lift them three times in 2017. At the same time the ECB refinancing rate remains at zero with the rhetoric very much focussed on ‘whatever it takes’ to boost both economic growth and stoke inflation. Meanwhile in the UK, the MPC also look to be on hold at 0.25%, in reaction to a slowing 2017 economic growth created largely by the Brexit uncertainty.

The back up in US yields was largely a reaction to the fact that Trump and the Republican Party are in control of both the Senate and the House of Representatives. This means the key policies of significant infrastructure spending and corporate tax cuts are likely to get through. Both of which are inflationary, increase Government borrowing and thus negative for bonds. Indeed, some would argue that the US is probably the economy that least needs such stimulus and simply brings the next recession that bit closer.

In the UK there has also been an upwards shift in inflation expectations with rising producer prices and while a lot of that is down to the decline in the pound in the wake of the Brexit vote, inflation was already trending up prior to the vote in any case. November’s Consumer Prices Index (CPI) inflation rate of 1.2%, was the highest since October 2014, when it stood at 1.3%.Inflation as measured by the Retail Prices Index (RPI), which includes housing costs, rose from 2% in October to 2.2% in November. The Bank of England expects inflation to continue to rise during 2017 to 2.7% and remain above the 2% target until 2020.

Against this backdrop conventional Ten Year Gilt yields have risen from 0.75% at the end of the last quarter to finish the year at over 1.43%. It is worth remembering that large parts of the world have still been increasing debt levels, so there comes a point when such large shifts in yields cause real pain. Whilst maintain the stimulus, the ECB did at least cut the volume in its asset purchasing, somewhat of a concession to Germany. ECB President Mario Draghi said the bond buys would be cut to 60 billion euros a month from 80 billion euros starting April but they would go on until the end of 2017, three months longer than expected. The ECB does continue to suppress European corporate yields as part of its buying programme. The differential against the US is likely to see investors switching to get the yield pick-up.

The rise in Sovereign bond yields is also unhelpful for the corporate sector which has been very active in recent years in issuing new paper. Indeed, just in the US in the past decade, corporate debt has increased by 75% to nearly $8.5 trillion. Critics would argue that much of the issuance has not been used for capital expenditure or corporate expansion but more balance sheet engineering through share buybacks and higher levels of stock dividends. Note very sustainable!

The high yield debt market has continued to see spreads tighten, although the default levels remain higher than normal, largely due to the energy sector fall out from last year’s sharp crude oil decline. The sector should still be well supported going forwards and also benefits from a relatively low duration which shields investors from the worst of the volatility.

With inflation back on investor’s lips index linked bonds are sure to be back in focus. Some argue that QE may have stored up inflationary pressures for the future that are yet to be felt. Demand for inflation-linked securities is largely driven by expectations of future inflation, although their long duration characteristics have also seen them perform well given long term pension funding concerns. A recent UK auction of index-linked bonds attracted more than £10 billion in orders for a £2.25 billion offer, highlighting the scale investor demand. The ten year breakeven level has now moved up to 3% in the UK and 2% in the US.