How and When Will Bond Conditions Change?

How and When Will Bond Conditions Change?

Q4 2016 CIO Insights: Fixed Income

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Bond investors have enjoyed an extended run of positive performance. Because it’s been our experience that markets are inherently self-correcting, we’re weighing bond market risks as yields stay low and credit spreads stay narrow. What could change, and when?

Our CIO Insights Introduction piece this quarter (Global Political, Emotional Undertones Contributing to Unusual Market Behavior) discusses the unusual global conditions that have simultaneously pushed the yields of U.S. Treasuries and high-yield corporate bonds lower and U.S. stock prices higher.

These simultaneous bond and equity rallies were largely generated by the following two factors:

  1. Extraordinary monetary stimulus programs by central banks around the world.
  2. Relentless demand for yield—investors buying anything with higher yields, including high-yield corporate securities, asset- and mortgage-backed securities, and longer-maturity U.S. Treasury securities.

Risk assessment and risk management are critical parts of our active investment management process. We watch the markets and bond issuers carefully to assess whether portfolio positions are adequately compensated for risk and how liquid they are if we want/need to exit them.

“Risk assessment and risk management are critical parts of our active investment management process.”

As government bond yields around the world continue to hover near all-time lows, and credit spreads stay narrow, our Global Macro Strategy and Risk Management teams are constantly asking: How and when could these conditions change? And, what’s more likely to change, interest rates or credit spreads?

Why Interest Rates Are Low

The answers are primarily fundamental/economic. Economic growth in the world’s developed economies remains weak and vulnerable, with the full impact of Brexit (the United Kingdom’s vote to exit the European Union) yet to be determined. In July, the International Monetary Fund estimated that the world’s advanced economies would grow just 1.8% in 2016 and 2017, motivating the world’s central banks to continue aggressive stimulus programs.

Rates are also low because of low global inflation, reflecting the influences of China’s lower growth and demand, lower energy prices, other reduced commodities prices, and a stronger U.S. dollar. Low growth + low inflation = low interest rates.

Why Credit Spreads Narrowed

The reasons are more technical than fundamental, based on supply and demand. While the economic and financial fundamentals for credit sectors are OK, strong investor demand for yield was the primary narrowing factor recently.

Two other key factors involved the U.S. stock market. First was year-to-date (through August 31) stock performance—when equities perform well, credit spread sectors also tend to perform relatively well. Second was low equity market volatility after Brexit, which we think gave investors confidence to chase higher yields.

What Will Change First?

So, our risk assessment boils down to: What’s more likely to change, the fundamentals for low interest rates, or the technicals and sentiment for narrow credit spreads? We don’t foresee big changes in either area in the near term, but we think the balance of risks leans toward credit spreads widening, especially if equity market volatility increases from August’s very low levels.

What if the Federal Reserve (Fed) raises interest rates? That would provide another reason for spreads to widen. But we don’t think the Fed is likely to move until at least December because of low global inflation and the uncertainties surrounding global growth, Brexit, and the U.S. election. And if it does move, the rate increase(s) would be small, U.S. short-term rates would still be low and stimulative, and we believe longer-term rates would remain largely suppressed by global fundamentals, demand, and the low yields of non-U.S. bonds.

Generally, as interest rates rise, bond values will decline. The opposite is true when
interest rates decline.

The opinions expressed are those of G. David MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice.