CIO Lens: We need to talk about yields
It remains a challenging investment environment where patience and teamwork are key, but bond yields are starting to draw our attention.
At the beginning of the summer, I asked the question “are we there yet?”, in relation to whether it was time to start thinking about taking on more investment risk. The answer then was no.
- Watch this quarter's CIO Lens video by clicking play at the top of this page.
At that time, although market valuations had cheapened, we were still concerned that investors were underestimating inflationary risks, being premature in their expectation of a “Fed pivot” away from interest rate hikes, and had elevated expectations for corporate earnings.
Inflation over growth
So, what’s changed since then?
It’s clear that central banks are willing to sacrifice growth at the altar of quelling inflation; investors are now moving from denial to acceptance of this.
The US 10-year nominal Treasury yield is 4% and the 10-year real yield (that is, adjusted for inflation) is above 1%. Significant rate increases from the major central banks are reflected in prices. So too is a recession, as seen in the “inverted” yield curve, which is when short-term bond yields are higher than long-term.
As we said last quarter, we are entering the phase of the cycle where investors expectation for growth are disappointed. This is currently seen in deteriorating corporate earnings revisions. As liquidity tightens, we have also started to see the first signs of stress; most evidently at the moment in the UK government bond market, with potential repercussions for other assets as UK defined benefit pension plans look to rebuild collateral buffers.
Where do we go from here?
It is important to remember that this isn’t the first time we have seen bear markets driven by rising interest rates. History doesn't repeat, but it rhymes. The sources of fragility will vary from cycle to cycle, but as active investors we have the frameworks to price these challenges and consider relative valuations across asset classes.
The improvement in valuations is most obvious in fixed income markets. We think it is now time to start talking about yield.
For example, US investment-grade bonds – that is, those deemed by credit agencies to be the highest quality - have gone from a yield of 2.2% 12 months ago to a yield of 5.6% at the time I write this.
High yield (debt with a credit rating below investment grade) and hard currency (US dollar) emerging market debt offer yields above 9%.
This shows that we are starting to be rewarded for taking risk in bonds as higher starting yields also act as an income cushion for investors against the impact of further price declines.
Rising yields means falling prices, but with higher income a portfolio of bonds can withstand a larger increase in yields before total returns turn negative.
Taking into account the different interest rate sensitivity or “duration” of bonds, what this means today in the case of US investment grade is that yields could rise by 0.8% and this would lead to a price fall of 5.6%. However, this would be offset by the 5.6% yield, or income, on offer.
What are the caveats? To benefit from yields, you need to be a medium-term investor to withstand any near-term volatility - as we head into recession, credit spreads could widen further.
The credit spread is the difference in yield between bonds of a similar maturity but with different credit quality. As spreads widen, this tends to mean yields rise/prices fall.
Nevertheless, if you are still with me after this technical passage, it is now possible to construct more positive scenarios for bonds as we head into 2023.
Data based on ICE BAML bond indices other than EMD which are JP Morgan. Source: ICE Data Indices, JP Morgan, Refinitiv, Schroders. As at 30 September 2022, in USD.
We are still cautious on equities as we need corporate earnings expectations to adjust down further.
So, aside from capitulation on the corporate earnings front, what would be triggers for us to become more bullish? Signs of slowing in either commodity price inflation or wage growth would be encouraging, as they would allow central banks to back off from raising rates. For now patience is still a virtue.
Team work in tough times
As the bad news keeps on coming, many people are struggling. At times like this, whether it’s in the community or in the workplace, people need support from their family, friends and colleagues.
Investment teams are no different, and that’s why human behaviour and a supportive culture should be an inextricable part of any investment process.
It’s more important than ever to draw on this culture; to ensure everyone keeps a cool head and to ensure that team morale isn’t impacted by frustration about events that are out of our hands.
We need to ensure that we continue to debate vigorously and scrutinise our positions, while also cultivating a supportive environment for our fund managers and analysts.
As investors, we are used to living with regret; there is always a better decision we could have taken. But the risk of regret is magnified when volatility increases.
At Schroders we believe in each investment team being accountable for its performance and process. There are many ways to skin a cat, but there are some common attributes among the best team leaders. Typically, they are honest about their wrong turns, humble in their management of risk and open to the opinions of others, no matter how junior. This is what ultimately allows them to navigate difficult markets.
Across the teams we also strive to create a supportive investment community, where insights, as well as the trials and tribulations of money management, are shared.
I often say that I could show you all of our investment models but it wouldn't tell you how to manage portfolios; it is our culture that sets us apart. It is our edge.
This year more than most has certainly showed us the benefits of being part of our community of active investors. And we are highly motivated by the investment opportunities which are likely to arise in the next few months.
Watch this quarter's CIO Lens video by clicking play at the top of this page.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.