However, ongoing very low yields justify maintaining an active investment strategy that takes a holistic, unconstrained approach. The "euro aggregate" universe seems particularly vulnerable.
The political uncertainty facing the financial markets in the spring has now largely faded. The outcome of France's presidential and parliamentary elections has been welcomed by the markets, while the UK's snap election has had no impact, with the Brexit process continuing as expected. In addition, the rhetoric from European leaders has turned positive again, and Emmanuel Macron's victory in France is giving a new lease of life to the Franco-German partnership. Although the situation in Italy could still create volatility, peak political uncertainty seems to be firmly behind us, and the situation has become much calmer in the bond markets.
That is especially true given that monetary-policy adjustments by western central banks are also unlikely to destabilise the markets. In the USA, the Fed is gradually raising its official interest rates. In Europe, the ECB has announced that it will not be cutting policy rates any further, and it has reduced the pace of its bond purchases. As a result, the prospect of a sharp increase in interest rates causing a bond crash – which many investors still feared in the first half of 2017 – seems to have been ruled out, and recent communication by the Fed and ECB has been broadly in line with market expectations.
The Fed's plan to reduce its balance sheet has not come as a surprise to traders, although it was mentioned a little earlier than expected. Measures to reduce the Fed's balance sheet are highly likely to start in September. The next Fed funds rate hike, meanwhile, could be announced in December. However, the consensus forecast of three rate hikes in 2018 looks overdone. The pragmatic approach would be to wait and see what the FOMC does in its next few meetings before forecasting how quickly monetary policy will return to normal in 2018.
A flexible and holistic approach to the bond markets in order to reduce risk exposure
Although the situation in the bond market has become clearer, investors should not ignore interest-rate risk, because bond yields are still extremely low, particularly in Europe.
In the circumstances, active management is vital to protect portfolios against yields rising – even gradually – in the wake of US movements. Investors need to look beyond the "euro aggregate" universe to find alternatives offering greater protection. The current situation requires a holistic, unconstrained approach to the bond markets.
As in the last few months, we have several preferred investment themes. US credit remains attractively valued compared with its European equivalent. It is true that renewed uncertainty about the direction of oil prices could prevent US corporate bond prices from rallying. Oil prices are currently moving within a range of $42-55, similar to levels seen in 2015 and 2016. However, today's situation is different: back then, the ISM index was at 48 and there was concern that the USA would fall back into recession, putting significant downward pressure on oil prices. Today, the health of the US economy is no longer in question. The current low level of oil prices is due solely to the inability of oil-producing countries to agree to adjust production.
Similarly, the US high-yield segment, where CDS spreads are currently 70 basis points higher than their 5-year average on a carry and roll-down basis, is still offering value. Investors can optimise their income profile by investing in the US high-yield segment via derivatives like CDSs. High-yield CDSs remain cheap relative to the prices of their underlying bonds.
Finally, subordinated bank debt also remains attractive, provided that investments are selected carefully. The recent events with Banco Popolare and the Veneto region banks means that investors should focus on systemically important banks, to the extent that these larger institutions have already cleaned up their balance sheets and restructured their businesses. By taking a flexible approach to the bond markets, these investment ideas help to reduce portfolio risk.
Christel Rendu de Lint
Head of Global & Absolute Fixed Income