In a nutshell
Safe government bonds offer attractive yields, but are not quite as interesting as other segments.
European corporate bonds remain in demand at high interest rates; we prefer the financial sector.
Emerging market bonds are back in vogue, local currencies with the best risk-reward ratio.
Constructive start to the year is not a flash in the pan
“Interest rates are back”, we wrote in the last issue of “Horizon”, and the first weeks of the year brought rising demand for fixed-income securities in many segments. Adequate yields and interesting coupons again provide for continued attractiveness despite temporary setbacks. We expect positive returns from bonds in the coming months.
Government bonds provide yields again; the US remains in the lead
As expected, the losses of the previous year in the safe government bond segment did not continue during the first quarter. Although the recovery that started at the beginning of the year initially slowed down from the end of January, and yields subsequently climbed above the levels they were at the turn of the year, the trend reversed again. Going forward, current yields should be the main source of return, with the fact that inflation in the US is on the retreat earlier than in the Eurozone playing a role. In addition to an easing in long-dated bonds, this also leads to a divergence in central-bank policies. The US Fed and the Bank of England should begin to lower their key interest rates again in the second half of the year after further hikes in the second quarter, but the European Central Bank will not. In the Eurozone, we expect a total increase in the main refinancing rate to 4% by the summer, without a turnaround in the following months. Overall, the segment has clearly gained in attractiveness and adequate current yields are again being offered in all three currency regions.
Welcome back - demand for corporate bonds is rising
European corporate bonds in the investment-grade segment have held up well since the beginning of the year. The attractive risk premiums and the increased yield level attracted investors. This led to a slight decline in risk premiums. Even though the valuation now appears somewhat less attractive and the potential for a further narrowing of spreads is limited, we maintain our overall positive view. At over 4%, corporate bond yields are at their highest level in more than a decade. In addition, it is evident that yield-oriented investors, who have shifted to alternatives in the negative interest rate environment, are again showing interest in European corporate bonds, thus strengthening demand. This is partly met by the well-filled new issue pipeline, and we also continue to favour new issues as they offer a yield premium over outstanding bonds. Moreover, their coupon is at current market levels, which strengthens the generation of current income after years of very low coupons (see figure below left). Within corporate bonds, we prefer the financial sector. The balance sheet quality of European banks has improved significantly in recent years. In addition to a significantly higher equity base, this is also reflected in the decline in the share of non-performing loans, as recently confirmed by aggregate data from the European Banking Authority. Compared with corporate bonds, the yields of financial securities are also higher and the maturity risks lower.
Emerging-market bonds: local-currency advantage
Emerging-market bonds were in a state of flux in the first quarter. While the start of the year was still promising and all three segments, ie both government and corporate bonds in hard currencies as well as local-currency bonds, were flushed upwards as part of a general liquidity rally, a reversal set in at the beginning of February after the strong US labour market data with rising US yields and a strengthening US dollar. The fact that the market performance proved to be very homogeneous across all asset segments, not only in the upward but also in the downward movement, shows that general risk sentiment was the dominant force for performance or that the market was driven by the movement of US yields and the US dollar, while individual country, sector or currency risks took a back seat. We expect this to change in the second half of the year at the latest, and the market to become more heterogeneous. In this case, we expect performance advantages in the local-currency segment. Compared with the hard-currency segment, the strongly increased local yields already offer an attractive current interest rate (“carry”) with a lower duration. If the rate hike cycles in the emerging markets end earlier than in the US and Europe, price performance will gain in importance again in addition to carry. Thus, in the course of the year, a gradual increase in duration in the market for local currency bonds seems opportune to us in order to participate in this development.
Conclusion: opportunities in all segments
After the “return of interest rates”, we see opportunities in all three bond segments discussed here. Safe government bonds again offer interesting current interest rates, but the European corporate sector is even more attractive. Here we prefer the financial sector, and we also participate in new issues with yield premiums and adequate coupons. Finally, emerging markets will develop more heterogeneously over the course of the year than they have recently, which should benefit local currency bonds in particular. The latter and corporate bonds remain our favourites.
Martin Mayer, CEFA, has been working as a portfolio manager since 1998. Since November 2009, as Senior Portfolio Manager at Berenberg, he has been responsible for the pension strategy of private asset management and for individual special mandates. After completing his training in business administration (Wirtschaftsakademie) and his degree in economics (University of Hamburg), he joined Deutsche Bank's asset management department in 1998. Until 2008, he managed individual client portfolios for Private Wealth Management and completed further training as a CEFA investment analyst/DVFA in 2001/2002. Mayer joined HSH Nordbank in the summer of 2008 as Deputy Head of Portfolio Management.
Felix Stern joined the Asset Management division of Berenberg in 2000 as a fixed income portfolio manager. Currently he is heading the fixed income selection team within the Asset Management and is responsible for institutional mandates. As a senior portfolio manager he is responsible for the selection of corporate and financial bonds as well as short-term bond market investments. He is also the lead manager for several of Berenbergs institutional mutual funds. Prior to joining Berenberg, he worked several years for the Market Research department of British American Tobacco, Germany. Felix is a CCrA - Certified Credit Analyst (DVFA) and also has a German Diploma in business economics from the Fernuniversität in Hagen.
Robert Reichle, CFA, CQF joined Berenberg as a senior portfolio manager in January 2010. As a member of the fixed income selection team he is responsible for the creation and implementation of global fixed income portfolio management strategies. He has expertise in emerging markets debt, global government bonds, as well as corporates and financials. He is also the lead manager of the Berenberg mutual funds Emerging Markets Bond Selection, Global Bond Selection, and EUR Government Bond Selection. Robert has been working in the financial sector since 2004. Before joining Berenberg he was a senior strategist and portfolio manager at Payden & Rygel in Los Angeles and he also worked at WestLB AG, London as a manager in Emerging Markets credit derivatives trading and structuring. Robert is a Chartered Financial Analyst (CFA), received the CQF designation, and also has a German Diplom in economics from the University of Ulm and a Master in international economics from the University of Pantheon-Sorbonne, Paris.