13th January 2017
Navigating the uncertain geopolitical and economic landscape in 2017 will require a search for relative rather than absolute value, says John McNeill, co-manager of the Kames Absolute Return Bond Global Fund.
In a low-yield environment in which absolute value is scarce and “passive exposure to fixed income makes no sense”, McNeill says investors seeking an alternative to cash should consider opportunities in three types of rates trades: cross-market, yield curve and inflation break-even.
“In cross-market terms the gap between US five-year notes and the equivalent German bonds has never been wider in modern times, around a 2.5% differential,” he says. “These are the sort of extreme valuations that we seek to identify and exploit, although one must be careful: what can look like an attractive spread on the surface can prove to be a mirage once the currency hedge is taken into account.”
In terms of the yield curve, McNeill says diverging central bank actions will provide investors with attractive opportunities. “The spread between five-year and 30-year US Treasuries is around 1.1% currently.
“If the Federal Reserve is less aggressive than is currently priced in the market we would expect this curve to steepen towards 1.4%. If the data is stronger than expected, and the Fed brings forward its tightening bias, this curve could easily flatten towards 0.8% or lower.”
With respect to inflation break-even opportunities, McNeill says investors may be surprised by a more hawkish Bank of England in 2017. “After the UK referendum result, inflation expectations as priced by index-linked gilts rose substantially,” he says. “Our view is that current pricing projects a gloomy view of persistently high inflation in the UK. We feel that the authorities will not be as tolerant of runaway inflation as many assume. The emphasis will be on maintaining financial stability and confidence in Britain as an investment destination. For this reason we will seek opportunities to lean against what we consider excessively pessimistic valuations.”
McNeill believes that the opposite policy approach is likely to be adopted in the US. “The new administration is likely to pursue a more pro-growth and protectionist policy mix which could drive inflation expectations higher,” he says.
McNeill says the Kames fixed income team is mindful that the credit cycle has matured, and that corporate leverage has increased in the US. He says the team does not see evidence of euphoria but points out that interest coverage has declined (although it is still at healthy levels given low funding costs).
“Quality curves continue to compress and yield pick-up for buying lower rated corporate bonds is only compelling if you think spreads will continue to tighten,” he says. “The grab for yield and willingness to take more credit risk for less spread compensation can be a signal of loss of market discipline.”
In sector terms, McNeill says financials offer compelling value versus industrials and utilities, particularly since regulatory change has led to less leveraged and better capitalised banks. “Other themes that we can exploit are asset class and country preferences,” he says. “The distorting effect of ECB quantitative easing makes the European credit market appear expensive relative to the US. This presents opportunities to take relative positions rather than being exposed to the general beta of the market.”
While the excess spread available from short-dated corporate bonds is lower than historical averages, McNeill adds that on a hold to maturity basis “this excess spread is worth harvesting as yields are likely to remain lower than historical norms”.