FIXED INCOME STRATEGY

Bonds are back

20/feb/2019
By Scott Thiel

Bonds are making a comeback. We see them as a viable source of income amid higher US interest rates, a slowing but growing US economy and a pause in the Federal Reserve’s tightening cycle. We also like government bonds as portfolio shock absorbers as the risk of late-cycle volatility in the equity market grows.

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  • Themes: A Fed on hold gives comfort to investors looking to move out of cash and money market funds in search of greater income – via longer-duration bonds and credit.

Equity bond correlations

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Thomson Reuters, February 2019. Notes: The line shows the correlation of daily returns between the MSCI USA Index (representing US equities) and the benchmark 10-year US Treasury over a one-year rolling period (256 trading days). The dot shows the correlation over the last 90 days.

We see low odds of a US recession in 2019, but potential for investors angst around slowing growth leading to risk-off episodes. Bonds should serve as a buffer in such scenarios, with correlation to equities deeper in negative territory. See the chart above. We believe this relationship has staying power, elevating bonds' role as a powerful diversification tool in balancing risk and reward in portfolios.   

  • Central banks: We expect the Fed to avoid raising rates until the second half, after it pledged a more patient and data-dependent stance on policy. Is this a pause or peak of the Fed’s tightening cycle? It depends on economic data in coming months, in particular inflation readings. We expect the European Central Bank to stay put on rates this year, and see its forward guidance as a focus for markets. 
  • Growth and inflation: We see US growth slowing as the economic cycle moves into the late stage. Ongoing monetary policy support is vital to Europe’s economy, we believe, while fiscal stimulus provides some cushion. We see China’s economy regaining its footing in the first half on policy easing, putting a floor under the synchronized slowdown in emerging market growth. We see inflation below target in Europe and Japan, while price pressures in the US look contained.
  • Risks: We view the probability of a US recession as low for 2019, though the odds are set to rise materially thereafter, as detailed in our 2019 Global investment outlook. Other risks include European fragmentation and an intensification of US-China trade disputes. Read our analyses on these and other key risks on our BlackRock geopolitical risk dashboard.

Fixed income views

Our views are from a US dollar perspective over a three-month horizon. Views and comments are from a fixed income-only perspective, and may differ from whole-portfolio tactical views on fixed income in our Global weekly commentary. For example, we overweight US credit and emerging market debt from a fixed income perspective because of their income potential. Yet we are neutral on these asset classes in a multi-asset context, where we prefer to take economic risk in equities.

 

Rates View Comments
US government bonds icon-up We see modestly soft economic news, positive fixed income flows and a first-half pause in Fed rate hikes as supportive. The impact of Fed balance sheet reduction should be muted. The front end has the most appealing risk-adjusted income, but we favor going out on the curve on any material backup in yields. A negative correlation with risk assets makes Treasuries attractive portfolio diversifiers. 
US inflation protected icon-neutral Treasury inflation-protected securities (TIPS) may look cheap, but fundamentals are weak in the short term. Inflation appears to be leveling off, and risk appetite is only gradually recovering. We see them moving higher as inflation normalizes in the medium term, but expect an uneven path.
US agency mortgages icon-down Current coupon mortgages look fully valued after strong performance in risk-adjusted terms. We see light overseas demand for the asset class in the short run, supporting our underweight.
US municipal bonds icon-neutral We prefer long-intermediate maturities for their attractive carry amid a steeper yield curve. We see supply-demand dynamics supporting the asset class in the near term as we expect new issuance to lag the total amount of debt that is called, refunded or matures.
Global rates ex US icon-down We steer away from most euro peripheral debt amid rising political risks, slowing economic momentum and fewer policy levers to counter any downturn. We see a no-deal Brexit as unlikely, but expect a bumpy road. We favor the British pound and underweight UK gilts in the medium term as a result.

 

Credit and other View Comments
US investment grade icon-up Solid fundamentals are supportive, but late-cycle economic concerns pose a risk to valuations. We favor BBB-rated bonds and emphasize credit selection.
US high yield icon-up We see generally healthy fundamentals, supportive supply-demand and reasonable valuations, and prefer bonds over loans. We like the asset class for its income potential.
US bank loans icon-down Ample supply and reduced demand for floating-rate products dampen the outlook for bank loans. We see opportunities to separate the wheat from the chaff after a surge in issuance in the past few years.
US securitized assets icon-up We like securitized assets for their income potential and stability. Credit selection is key, however, because of the diversity between and within the asset class’ subsectors.
Euro investment grade icon-neutral We are overall cautious on euro investment grade credit — but see attractive relative value and income potential in the BBB segment. Yields appear low on first glance but compare favorably when hedged back to the US dollar, mainly because of interest rate differentials between the eurozone and US.
Euro high yield icon-neutral We are neutral on European high yield but note significantly wider credit spreads versus equivalent US peers. We like the relatively high yields for their income potential.
Emerging market debt icon-up Valuations are attractive despite the recent rally, and limited issuance in recent months is supportive. A pause in US monetary policy tightening and US dollar strength remove a key drag on performance. Clear risks include deteriorating US-China relations and slower global growth.
Asia fixed income icon-up Easing US-China trade tensions would increase the appeal of the Chinese yuan. A focus on quality is prudent in credit. We favor investment grade in India, China and parts of the Middle East, and high yield in Indonesia and in Chinese real estate.

 

Chief Fixed Income Strategist, BlackRock Investment Institute
Scott Thiel, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views.

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