Main asset classes Sweet spots in credit

Sweet spots in credit

While returns on many of the highest quality bonds will likely be negative in 2020, there are still opportunities, including in the BB segment for high yield bonds.

With the global economy cooling amid ongoing US-China trade tensions, bond yields trended downward during much of 2019, generating substantial capital gains. At the time of writing, government and investment grade (IG) bonds were on track for a significantly stronger performance than in 2018 – this despite the fact that 35% of European IG corporate bonds were already trading at negative yields at the start of 2019.

Yields headed back up

According to our base case, the global economy should improve slightly in the coming year and IG and government bond yields are thus likely to rise. This would generate capital losses. As yield curves are still rather flat, the setback would be more severe for bonds with long maturities. Many high-quality bonds will therefore likely produce negative returns in 2020. If starting yields are very low or even negative, avoiding negative returns will be close to impossible.

We expect returns to be positive in only a few high-grade markets, such as US Treasuries or Australian government bonds. In contrast, returns are likely to be negative in much of the Eurozone and in Switzerland.

Positive returns are only likely in the case of a severe recession or geopolitical crisis. Then yields for the high-grade segment would further decline and the resulting capital gains could even outweigh negative starting yields.

Tighter times for credit

Spreads (the yield difference between riskier bonds and government bonds) in most credit segments also narrowed in 2019. Absolute yields thus dropped to very low levels in most segments. In some areas, yields now appear inadequate to compensate for the risk of worsening fundamentals and rising defaults.

This applies in particular to those debtors with a very low rating (e.g. single B) that are strongly exposed if the global economy further weakens. Moreover, leverage has increased in cyclically vulnerable areas such as steel and energy.

However, yields in some credit segments, both within IG and high yield (HY), look sufficient to compensate for such risks even if they are low. The following pages provide more detail on the opportunities and risks in 2020 for fixed income.

Spreads over core government bonds in basis points

Emerging market bonds offer good risk/return trade-off

Spreads over core government bonds in basis points

Narrow focus in investment grade

Backdrop: Although yields in IG are very low in absolute terms, we continue to see attractive opportunities. Most of these bonds are unlikely to face downgrades even in an environment of subdued economic growth.

Opportunities: We see interesting opportunities in emerging market (EM) investment-grade dollar corporate bonds, not least in some Asian markets, where worries over the impact of the US-China trade war have triggered a rise in spreads even though corporate fundamentals remain sound. Some European hybrids in non-cyclical sectors such as utilities and communication also offer interesting risk-adjusted returns.

High yield: Focus on subordinated financials

Backdrop: HY spreads could continue to widen as long as recession fears have not been overcome, with B rated bonds most vulnerable to a sharper rise in yields. However, we continue to see opportunities in the slightly better BB segment. 

Opportunities: This includes subordinated financial bonds. Ongoing regulatory pressure to strengthen bank balance sheets and the trend decline in non-performing loans, not least in the European periphery, should be supportive. HY bonds that conform to environmental, social and governance (ESG) standards are of increasing interest and relevance as well.

Emerging market bonds: Good risk/return 

Backdrop: Spreads have declined less in the main EM bond indexes since the 2008 financial crisis than in a number of higher risk credit segments in developed markets, where leverage is often higher. The latter may have benefited more strongly, albeit indirectly, from central banks’ asset purchase programs, which focused on advanced economy bonds. Conversely, EM bonds now offer a higher risk premium from which investors can benefit. 

Opportunities: The US Federal Reserve’s more accommodative stance should continue to benefit EM that are reliant on USD funding. Economic fundamentals in some of the large borrowing countries such as Brazil, Mexico and Turkey should continue to improve in 2020. Declining inflation rates should help bring down domestic interest rates in a number of countries, which would, in particular, support EM local currency bonds. However, as some currencies may come under pressure, a selective approach is required.

Be conservative with asset-backed securities 

Backdrop: Structured credit instruments, more generally known as asset-backed securities (ABS), are considered a primary catalyst for the 2008 financial crisis and have often been regarded with skepticism since then. However, we see various interesting opportunities in this area. But caution is advised in some areas including some of the traditional US and European ABS markets. 

Opportunities: European covered bonds still offer moderate returns and a high credit rating. Collateralized loan obligations (CLO), especially senior and mezzanine tranches, also offer a good riskreturn tradeoff. They are typically much less affected by rising defaults than HY bonds or leveraged loans. Moreover, their floating rate nature provides a buffer against rising longer-term yields. In contrast, more than half of the US ABS issuers are from the automobile industry, which is undergoing structural change.