We continue to be constructive on government bonds despite the very low level of yields. The Federal Reserve’s stated policy of allowing higher inflation and periods of overshooting the inflation target cannot be met if real yields are allowed to rise. Yields can only go up so much in such a highly indebted world.
We remain firmly of the view that we are in a deflationary environment rather than an inflationary one. The outlook for the economic recovery seems to have deteriorated, and for inflation to increase, economic activity will have to recover sharply. Demographics and technological disruption are powerful long-term suppressants of government bond yields, and the huge rise in debt levels over the crisis is likely to remain a drag on economies for some time.
Investment grade and high yield bonds are a good place to be because of central bank support, but you must get your credit analysis right. The economic growth outlook continues to be challenged, and that leaves a lot of business models looking highly questionable, in particular, companies that are heavily exposed to the economic cycle and those that are highly leveraged. Default rates have climbed in the US and will continue to do so, and some well-known companies have filed for bankruptcy this year.
Rising debt levels leads to falling yields
Make it a takeaway
In high yield, we see opportunities in BB rated companies and in more defensive sectors. With the right credit selection, investors can pick up yields in a range from 3% to double digits in names that will provide the opportunity to get the coupon plus the return of principle.
In investment grade in March, spreads implied significant default rates. There were compelling opportunities in BBB and single A, and while much of that has played out, you are still able to get in these select names over and above what you can get in government bonds. Global flexible bond investors also have a range of tools available to look to preserve capital. That includes credit default swaps to mitigate risk, AAA rated sovereigns, and the use of currency as a hedge. We continue to favour AAA sovereigns because, as we said, we believe the world is more susceptible to a deflationary shock than an inflationary one. Covid-19 seems like it is going to be with us for some time, and it has created a lot of scarring for the global economy.
Ten-year Chinese government bonds are one of the few sovereigns offering a positive real yield today at around 3%. Meanwhile, five-year Russian government bonds in local currency offer yields in excess of 5%. Russia has some big problems, including demographics, and we think rates there will move lower over time so there could be potential for capital appreciation.
Our view is that within the current monetary framework it is going to be difficult to generate inflation, and therefore the benign outlook for government bonds and corporate debt is very much intact. Flexibility is going to be crucial in what will undoubtedly be a challenging macro environment over the next 3 to 5 years, and global flexible bond strategies offer the tools to manoeuvre through that world.
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