Calculation tool View your return

Use the Calculation tool and see
the return on your assets


Quarterly Bulletin Investment Outlook

An exclusive opportunity to receive
the Wealtheon Investment Outlook


2016, the last great year for bonds

25 August 2016,

Although the year is far from over, as the summer season, which is often accompanied by volatility,  draws to a close, we note that for the time being 2016 has been a good year for bonds.

Bond indices have returned positive performances, and at the time of drafting this article, they have outperformed many equity indices.

In the US, although the Federal Reserve (Fed) has adopted a relatively hawkish policy by tightening Fed funds rates early in the year, with a second potential hike expected before year end, US government bonds, known as treasuries, have returned +4.4% since the beginning of the year, slightly outperforming the Nasdaq tech stock index (+4.2%) and trailing the S&P 500 and Dow Jones indices, which are approaching their all-time highs, having returned +6.3% in local currency.

The divergence in performance is much more striking in Europe however. With the exception of Norway and the Netherlands, which have been driven higher by the commodities price rally, large cap equity indices in Western Europe have posted negative performances, with the Eurostoxx 50 returning -9%, the CAC 40 in Paris ‑5%, Madrid -10% and Milan -22%! In contrast, the European bond market has recorded relatively steady returns. At the beginning of the year, it was inconceivable for bond markets to post this type of performance, with rates already tipping into negative territory. Even long-term rates were negative at the end of August, with 10-year German Bunds yielding -0.06%, which means that investors are prepared to lose capital in order to own highly creditworthy German debt.

Italian bonds across all maturities (>1 year) have retuned a year-to-date performance of +4.6%, whereas the FTSE MIB benchmark equity index has tumbled by 22%, chiefly on account of fears over the stability of the banking system, due to the weight of non-performing loans on the balance sheets of the domestic banks, exacerbated by failed stress-tests and the creation of a recapitalisation fund. Spanish Bonos have returned+7%, (+11% among 7/10-year maturities).  Belgian government bonds have also performed strongly, returning + 9% since the beginning of the year. France and Germany have underperformed marginally.

In contrast to the tighter monetary policy in the US, the ECB has maintained its highly accommodating strategy throughout 2016. In addition to the targeted longer-term refinancing operations (TLTRO), the ECB has lowered its base rates, to an unprecedented level which is “charging” 0.4% for the deposit facility, and has announced plans to buy-up sovereign and corporate debt in the secondary market. These operations are being carried out under a broad set of quantitative-easing measures in the form of the Public Sector Purchase Program (PSPP) and the Corporate Sector Purchase Program (CSPP). These programmes mechanically drove yields lower as they were anticipated by the markets and then implemented. The surprise pro-Brexit vote also boosted this asset class (see chart below).

These attractive performances are nonetheless risky! Longer portfolio duration has effectively generated higher returns. However, the slightest increase in interest rates may prove very costly for bonds. Furthermore, bond market liquidity is progressively drying-up and carry is no longer profitable. Many issues are being pitched with yields of 0%, 0.25% and 0.5%, even among relatively long-dated maturities. If interest rates steepen, it will take several years of carry to recoup losses.

Even though the bond market may continue to perform, we believe that the risk is too high to attempt to seek yield through duration or by investing in high-yield ratings. Above all, we prefer protecting bond portfolios through very short-dated duration and investment-grade ratings, via fixed or floating rate notes and inflation-linked securities, while endeavouring to capture any steepening among rates by setting up short index positions, until market conditions revert to normal. As this may take a long time yet, investors should seek yield in the equity markets.



More from this category