FIXED INCOME STRATEGY

Bonds are back

Apr 1, 2019
By Scott Thiel

Bonds are making a comeback. We see them as a viable source of income amid higher U.S. interest rates, a slowing but growing U.S. 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 U.S. equities) and the benchmark 10-year U.S. 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 U.S. 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 U.S. 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 U.S. look contained.
  • Risks: We view the probability of a U.S. 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 U.S.-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 U.S. 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 U.S. 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. Views are as of April 1.

 

Rates View Comments
U.S. government bonds icon-neutral We are cautious on U.S. Treasury valuations as markets have started to price in rate cuts after the dovish pivot by the Federal Reserve. We expect a gradual steepening of the yield curve, driven by still-solid U.S. growth, a Fed willing to tolerate inflation overshoots – and a potential shift in the Fed’s balance sheet toward shorter-term maturities. This supports two-to-five-year maturities.
U.S. inflation protected icon-up The Fed has confirmed its intent to be patient with its next rate move and may let inflation temporarily breach its 2% target. Along with a slowing but growing economy, we believe this makes inflation-protected securities an attractive alternative to nominal bonds.
U.S. 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.
U.S. municipal bonds icon-up We see coupon-like returns amid a benign interest rate backdrop and favorable supply-demand dynamics. New issuance is lagging the total amount of debt that is called, refunded or matures. The tax overhaul has made munis’ tax exempt status more attractive in many U.S. states, driving inflows.
Global rates ex U.S. icon-down Low yields, European political risks, and the potential for a market reassessment of easy European Central Bank policy or pessimistic euro area growth expectations all make us wary on European sovereigns, particularly peripherals. Yet any further deterioration in U.S.-European trade tensions could push yields even lower.

 

Credit and other View Comments
U.S. investment grade icon-up A slowing but growing economy, a reduction in macro volatility and a decline in issuance support credit markets. Conservative corporate behavior – including lower merger and acquisitions volume and a focus on balance sheet strength – also help. We favor BBB-rated bonds.
U.S. 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.
U.S. 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.
U.S. securitized assets icon-up We like securitized assets for their income potential, stability and diversified credit exposure. Cheaper valuations and lower volatility relative to investment grade credit also make the asset class attractive.
Euro investment grade icon-down “Low for longer” ECB policy should reduce market volatility and support credit as a source of income. European bank balance sheets have improved after years of repair, underpinning fundamentals. Yet valuations are rich after a dramatic rally.
Euro high yield icon-neutral We are neutral on European high yield but note significantly wider credit spreads versus equivalent U.S. peers, muted issuance and strong inflows. We like the relatively high yields for their income potential.
Emerging market debt icon-up Prospects for a turnaround in Chinese growth and a pause in U.S. dollar strength support both local- and hard-currency markets. Valuations are attractive despite the recent rally, with limited issuance adding to the positives. Risks include deteriorating U.S.-China relations and slower global growth.
Asia fixed income icon-up 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. We are cautious on Chinese government debt despite its inclusion in global indexes from April. We see increasing funding needs outstripping foreign inflows.

icon-up Overweight     icon-neutral Neutral     icon-down Underweight

Scott Thiel
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.