26 May 2020
James Foster, Manager of the Artemis Strategic Bond Fund
James Foster looks at the consequences of the crisis for bond markets. He discusses why inflation will likely tick up in future years and how this could impact yield curves – and what this means for returns from bonds.
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The economic outlook gets progressively worse. Lockdowns have proved to be more protracted than initially envisaged and the economic damage is likely to be very severe - worse than any historical recession.
But there are a couple of reasons to be optimistic. Firstly, some of the noises from the pharmaceutical companies about a Covid-19 vaccine are encouraging. If true, and quickly disseminated, then the world will return to ‘normal’ probably remarkably quickly. Secondly, governments have put in huge support for companies and employees. As soon as companies can operate, they will, and moreover banks are able to withstand some shocks as their balance sheets are healthy. Banks’ ability to absorb a few non-performing loans is much greater than in 2008; and that in turn allows them to continue to lend to support the economy.
However, it is impossible to believe this will not have far-reaching consequences for the economy and our focus, bond markets. Not least, companies are being downgraded and this will continue. So far, 14% of companies have been downgraded – that compares with 2008/09 when about 60% of companies were downgraded. We would expect similar numbers, though hopefully less. The rating agencies are working their way through their clients and will downgrade more – but they are always reactive.
Vast amounts of government bonds are being issued to pay for the costs of Covid-19. Mostly these are being absorbed by the steady programmes of quantitative easing. Yields have fallen over the last three weeks or so in the UK where the impact of Covid-19 is worse than many other European countries. Surprisingly, UK short term yields have even turned negative (a record low), suggesting that the Bank of England may resort to negative interest rates – unlikely, in our view. In the rest of the world, yields have been broadly unchanged.
The debates rage about the prospects for inflation. On the one hand, the shock to the system and higher unemployment will force prices lower. On the other, the rolling-back of globalisation and reduced capacity will push prices higher. Our view is that it will be the latter - inflationary. Not necessarily this year, but certainly over future years. As a result, with interest rates being kept low, but supply and inflation weighing on the longer end of the yield curve, we anticipate that yield curves will steepen. We will look to shorten the fund’s duration, at some stage, but probably not in the short term whilst the terrible economic numbers are still the primary focus. Currently it is 5.2years.
We have continued to increase our investment grade holdings, now 42% (from around 30% when the crisis started) mostly through the new issue market. Most recent purchases have been from companies such as Reckitt Benckiser, GSK and AT&T. All solid investment grade names, who should be more than able to withstand the economic shock. We have also maintained our bank and insurance company positions, which continue to perform well, as they have solid capital positions and have cut dividends (conserving cash for us - bondholders). This has been at the expense of our government bond positions which are now down to 29%.
Our high yield percentage is a touch higher at 30% (from around 26%), through some additions and the fact that our holdings have risen in value. Defaults will increase sharply for this sector, as the economic crisis evolves. It is inevitable that we will not avoid all of those defaults throughout the crisis, but we are positioning to avoid the sectors most adversely affected. Moreover, and most important, current prices reflect that increased risk so we are happy to maintain this level for now.
All in all, our portfolio is being repositioned to reflect the new environment. It is likely to be a world of more extremes. Greater defaults, probably greater inflation, more government intervention and more volatile markets. However, we feel that bond markets are likely to provide the most sensible returns in this volatile environment.
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