Market Views: What are the best alternatives to govvies?

With sovereign bonds yielding very little, capital has poured into US investment grade bonds. Is the risk/return trade-off worth it? AsianInvestor asked four experts for their views.
Market Views: What are the best alternatives to govvies?

Much agitated by the raging political and economic uncertainties across the world, investors looking for safe-haven assets have flocked to a wide range of developed market sovereign bonds.

But this has driven down yields to miniscule even negative levels, even if it has served up meaty capital gains in the short-term.

German 10-year bonds, for example, are currently priced to yield close to minus 0.70%, while two-year, five-year and 10-year Japanese government bonds are all yielding less than zero too. Ultra long-dated investment grade bonds, notably 100-year Austrian bonds, have seen some truly spectacular price gains (and, by extension, yield declines) in recent months.

What's more, with worries about a possible recession rising as economic growth slows, stymied by the trade war, a greater part of of the all-important US yield curve has started inverting. Because as more jittery investors have sought longer-dated US Treasuries rather than shorter-term ones, so yields on the former have fallen by more than the latter. As of Wednesday's close, for example, yields on one-year, two-year, three-year, five-year, 10-year and even 20-year US Treasuries were all trading below six-month t-bill yields of 1.87%.

Against such a backdrop, US corporate bonds and the like have become more attractive for institutional investors pursuing better returns, including Japanese asset owners. It is largely why, as the Financial Times reported, US investment grade bond funds were headed for their best August return in close to 40 years. And why Vanguard's long-term corporate bond ETF, for example, had returned 23.9% year-to-date as of September 5.

Some investors remain cautious though. Lawrence Chan, head of fixed income at the Raffles Family Office, of example, believes investment grade bonds in Asia may offer better risk-adjusted returns, or should at least be considered also for diversification purposes.

AsianInvestor asked four additional investment specialists whether US investment grade bonds still offer a sufficiently attractive risk/reward trade-off, given the global economic uncertainty. And as yields from sovereign bonds continue to contract, how else can asset owners find better risk-adjusted returns? Their answers follow below.

The following extracts have been edited for brevity and clarity.

Jason Low, senior investment strategist
DBS Bank

Jason Low
Jason Low

About 30% of the global investment-grade universe’s market value is now in negative yielding territory, driven by developed markets government and selected corporate bonds – a sign of the insatiable hunger for yield today.

In general, global yield spreads are very tight now. We, generally, see little value in the US investment grade corporate bond space given the tight spreads. For example, the Bloomberg Barclays US Corporate Bond Index now yields 2.77% on average, compared to 4.20% since the start of the year, with the yield spread now tightening to 1.25%, from 1.58% at the start of 2019.

Across the risk-rating spectrum, the sweet spot is in the BBB/BB basket where risk-adjusted value is the highest. We also see more value in the emerging markets segment after a recent widening of yield spreads, as opposed to the developed market segment where yield spreads have tightened.

Paul Sandhu, head of multi-asset quant solutions for Asia-Pacific
BNP Paribas Asset Management

Paul Sandhu
Paul Sandhu

US investment grade bonds have typically been a safe haven for investors during times of uncertainty but given the yield curve has been flattening and reached an inverted state in recent months, the short-term risk can’t be overlooked. 

For Asian investors, in particular, US investment grade bonds provide safety but at very low yield levels. One key strategy to managing downside risk in this current market is diversification over market allocation. 

So, whatever markets investors are domiciled in, make sure they are invested in a diversified manner globally. This also means that US bonds should be in the portfolio.

However, in the US, I still believe that coupled with moderate allocations to US investment grade bonds, high yield bonds and equity with downside protection is a must.

Belinda Liao, portfolio manager, Asia fixed income
Fidelity International

Amid macro uncertainties, it is essential for investors to capture “quality yield” in a risk-efficient manner, rather than simply chasing “yield at all costs”.

Belinda Liao_Fidelity International Portfolio Manager
Belinda Liao

Investment grade credit has been the main beneficiary of the search for income sparked by central bank actions, and it has enjoyed a strong rally in 2019.

The growing chorus of dovishness across central banks around the world should drive core rates lower, which would provide a good cushion for a long duration and high-quality asset class.

US investment grade corporate bonds have outperformed European Union investment grade bonds, whilst Asian investment grade bonds have recorded double-digit returns year to date.

Asia investment grade is likely to offer better value in terms of valuation, fundamental and technical support in the medium-to-long-term … It is supported by stable fundamentals, with Asian countries continuing to experience rating upgrades.

A very strong home bias within the Asia investment grade space, where Asian investors continue to buy Chinese and Asian names, also anchors a continued favourable technical backdrop.

Ramon Maronilla, investment specialist, global fixed income, currency and commodities
JP Morgan Asset Management

The backdrop is that macro uncertainty remains high as trade tensions continue to dominate markets. Questions have intensified about the timing of the next recession, which is likely to prove especially negative for lower-rated parts of the credit markets.

Ramon Maronilla, Investment Specialist, Global Fixed Income, Currency & Commodities, J.P. Morgan Asset Management
Ramon Maronilla

In this environment, there are reasons for some cautious optimism in investment grade credit. While leverage remains high compared to historical levels — a key concern for investors last year in particular — there are signs that companies have made concerted efforts to improve their balance sheets. In many BBB rated companies (the focus of investors’ concerns), leverage levels have decreased in 2019, with median gross leverage stabilising at around 2.6x in recent months.

At the same time, interest coverage ratios are very healthy at around 10x, with companies able to service their debt comfortably. This is encouraging: the last time the market saw similar leverage levels in 2001/02, interest coverage was significantly lower.

High-quality fixed income remains well bid, given stable credit fundamentals and a reasonable yield pickup over government debt, where rates have been falling steadily. If the current environment persists — and we do not expect trade tensions to go away any time soon — rates can continue to fall, and the asset class should benefit from the duration component.

For now, selective investment grade credit offers a high-quality alternative to government bonds.

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