Bonds - Renaissance of a currently undervalued asset class?
For years, bonds were outshone by equities. But the recent turnaround in monetary policy in the US and Europe, as well as the geopolitical situation, are weighing on equity prices. Adding to this are persistently high inflation and uncertainties with regard to the pandemic, as for example in China. Peter Lechner, bond expert and DJE co-fund manager responsible (among others) for the DJE - Short Term Bond, explains what investors should now know about bonds and what strengths bonds can now play to.
How do bonds perform in terms of maturities?
The bond curve in the USA is now clearly inverse. It means that papers with short maturities are yielding higher returns than those with longer maturities. This is uncommon because investors usually demand higher yields for longer fixed-interest periods. Historically, an inverted curve is considered a strong sign of recession.
At current interest rate levels, is the next Fed hike already priced in?
Yes. A total Fed funds rate increase of 100 to 125 basis points (based on April 21, 2022, as cutoff date) by the end of the year is likely to be largely priced into intermediate and longer maturities.
Where are interest rates heading?
This depends primarily on the domestic economy. Let's assume that oil and/or gas prices stop rising and the other factors in the basket go up only slightly. Then the technical method of calculation alone will result in a decline in inflation. We may see the peak in inflation in the third quarter. In our view, inflation rates should at least stabilize or even decline in the short to medium term.
Which bond market should investors pay particular attention to?
We still find U.S. bonds more attractive than European bonds due to the much higher interest rates. 10-year U.S. bonds currently yield 2.97%, while their European counterpart, the German Bund, yields 1.22%. So, if possible, it is advisable to buy U.S. bonds. However, it has to be said that one can not only gain but also lose via the currencies.
Focus on Europe: Are we likely to see more interest rate moves in the euro zone than the recent 50 basis point hike to now 0.5%?
Inflation was 8.6% in June, but the ECB has a long-term inflation target of no more than 2%. The market had priced in 25 basis points before the ECB's decision on July 21. However, the ECB was also under pressure to do more, as it has now done with the 50 basis points hike. We expect further interest rate steps in the coming months. With the Transmission Protection Instrument (TPI), the ECB has also introduced an instrument to control spreads, i.e. it wants to use it to keep the risk premiums for bonds of the southern European countries under control compared with, for example, German government bonds.
How do you assess the situation for corporate bonds?
Their yields are already attractive again. As of June 30, high-quality European corporate bonds (investment grade) were yielding around 3.24%; the level has since fallen somewhat and is currently 2.92%. The situation is similar for European high-yield bonds; however, the decline was less pronounced, from 7.92% to 7.65%. In the U.S., yields in the investment grade segment fell from 4.70% to 4.65% and in high yield from 8.89% to 8.47%.
Concerning sectors, aviation and travel performed well due to large Corona catch-up effects. However, the upcoming fall may bring new risks with regard to the pandemic. The automotive sector is rather risky, but reasonable returns can be achieved. The pharmaceutical sector is also attractive.
What should investors watch out for in corporate bonds?
Some of the spreads on high-yield bonds have reacted before equities. So you could see one or two sharp price declines here early on. In the current environment, you have to be very careful. In a recession, for example, high-yield issuers are hit particularly hard. Investors need to take a very close look at this segment in terms of opportunity and risk because of the higher default risks.
Growth costs more again: How does the interest rate level affect growth investments?
Many growth companies are bond issuers in the lower investment grade to high-yield range. When the economy is weaker, they face higher risk premiums when financing future growth.
What about the special form of subordinated bonds?
In some cases, there is hardly any liquidity available here. You should only buy subordinated bonds if you are absolutely sure that repayment is guaranteed. We only invest here if we are in close contact with the company and can get a good picture of the viability of the business strategy.
How short should the maturities be?
At DJE, we currently tend to aim for shorter maturities. The target duration of the portfolios is determined in the regular strategy meeting based on the criteria just mentioned. Basic portfolios sometimes include longer maturities, but with our derivative overlay management - e.g. hedging longer maturities by using interest rate futures - we can quickly regulate duration at the overall portfolio level depending on short-term market assessments.
Government bonds versus corporate bonds - how does DJE handle this issue?
We distinguish here between a strategic and a tactical component. Strategically, we build a broadly diversified base portfolio of government and corporate bonds with good credit ratings. To generate additional performance, we selectively add high-yield bonds that offer higher income, or foreign currency bonds. Tactically, we take advantage of special situations in the market and also regularly underwrite new bond issues. This year, however, we saw fewer exciting new corporate bond issues, as many issuers had already secured the very favorable refinancing conditions for the long term in the previous year. In the portfolio, we never focus too heavily on individual corporate securities, but are broadly positioned. In other words, we are less affected by possible deteriorations in issuers' credit ratings.
Have you become more cautious about corporate bonds because of the turnaround in interest rates?
We see some reversal in government versus corporate bonds: The past five to six years have been characterized by falling yields on government bonds. Here, we were heavily betting on corporate bonds because of their yield advantage, which was significant in some cases. This year, the balance has now turned, due to geopolitical risks, interest rate hike cycles and burgeoning inflation. As a result, we are now more pessimistic about the business environment for many companies and are focusing more on government bonds. In addition, however, we hold liquidity in order to be able to quickly access interesting corporate securities.
Note: Marketing advertisement - All information published here is for your information only and does not constitute investment advice or any other recommendation. The statements contained in this document reflect the current assessment of DJE Kapital AG. These may change at any time without prior notice. All statements made have been made with due care in accordance with the state of knowledge at the time of preparation. However, no guarantee and no liability can be assumed for the correctness and completeness.