Invesco: 2019 investment outlook – Henley Fixed Interest team

The macroeconomic view — Stuart Edwards

As we look ahead to 2019, the US economy is, in my view, in pretty good shape. However, with the fiscal (government spending) stimulus that has been such a driver of recent growth coming to an end and trade tensions an ongoing concern, economic growth has likely peaked and could now fade. Meanwhile we are, so far, yet to see any meaningful pick-up in the rate of inflation. 

Against this backdrop, the US Federal Reserve (Fed) is three years into its current interest rate hiking cycle. As US bond yields have adjusted to a higher interest rate, so too has the balance of risk and return for US government bonds, making the US a potentially competitive source of income. In turn, this has led investors to demand a higher premium to invest in more challenged areas of the fixed income market. At times over the past 12-months this re-pricing has created opportunities that we have sought to exploit.

As the challenges of monetary policy changes and global trade play out over the coming year, I would expect further tactical and strategic investment opportunities to present themselves. The flexibility to be able to exploit such opportunities will, I believe, be important to delivering returns in what could be another difficult year for bond markets.

High yield — Thomas Moore

As we look forward to 2019 corporate financial Leverage is ticking up, quantitative easing (QE) is being withdrawn, and although there has been some push-back on more aggressive financings (deals that include terms very favourable to the issuer), the market is still a long way from being what I would consider creditor-friendly.

On the other hand, companies are generally in a good position to service the debt they now hold.  Furthermore, from a top-down perspective, global economic growth remains reasonably strong (despite the challenges to trade), unemployment is low and although inflation has increased, it is also still low.

High yield default rates (the percentage of issuers unable to make scheduled payments) also look set to remain subdued in my view. The longer period of very low interest rates and the demand for yield has enabled much of the high yield sector to increase the maturity of its debt. I therefore do not expect default rates to increase materially in the near term, with only those companies that have challenged business models at risk of insolvency.

One further important trend within high yield markets this year has been the increase in the dispersion of returns. Analysis by Morgan Stanley of the price return (i.e. excluding income) of the high yield bond market in 2017, showed that 60% of the market provided a positive price return and 40% a negative return.  This year, just 10% of the market has provided a positive return with 90% providing a negative return. The implications of this are, I think, clear. First, simply allocating to the sector to harvest price returns is likely to be a costly strategy and secondly, this highlights the ongoing importance of security selection within high yield bond markets.

At the time of writing we have seen some value come back into parts of the high yield market, and where appropriate we are seeking to exploit these. That said, with the market facing multiple headwinds, including the withdrawal of QE, Brexit, and tensions over global trade, we are cautious. As in 2018, I expect 2019 to be a year in which security selection and thorough due diligence will be crucial to delivering returns.

Investment grade — Michael Matthews

During 2018, investment grade corporate bond markets faced a number of challenges that led to significant re-pricing of some parts of the market. Where appropriate we sought to exploit the investment opportunities this re-pricing created. Looking ahead to 2019, many of the challenges facing markets remain unresolved and so could provide further periods of volatility that we are able to exploit.

The challenges

• The US Federal Reserve’s tightening of monetary policy (increasing interest rates and removal of QE) has helped increase US government bond yields. Hedging the US dollar exposure back to either euro or sterling means a large part of this yield is given up. Nonetheless, with US government bonds offering a local currency return comparable with European credit markets the demand for the latter has fallen.
• As the Fed has increased interest rates, the US yield curve has become flatter (the difference in yield between short and long dated bonds has fallen). There has been much speculation about whether this flattening will continue and lead to the curve inverting (short dated bonds yielding more than longer dated bonds) and whether this in turn would portend a recession in the US economy. Whether it does or not is difficult to say, but as bond investors what is clear is that with the little difference in yield between short and long dated bonds there is little reward to be gained from extending portfolio duration (sensitivity to interest rate changes).
• Rising global trade tensions, the new Italian government’s budget proposals and concerns about emerging markets have all contributed to an increase in market volatility during 2018. As noted above, the German Bund market has been one of the beneficiaries of this volatility as investors have sought these potentially less volatile assets.
• Central banks are reducing the amount of liquidity they are providing financial markets (the ease of buying and selling assets). Throughout 2018, the amount of bonds being purchased through QE programmes has fallen. It will however not be until 2019 that the central banks combined will actually be purchasing less bonds than are sold.
• The liquidity of bond markets has been an ongoing cause of concern since the global financial crisis and the changes that came into force as a result. To date liquidity of the market has not been tested.

Faced with these challenges we are cautious. We are maintaining a high level of liquidity in funds through cash, government bonds and bonds with less than a year to maturity or call. This helps to mitigate the impact of periods of market weakness. However, as we have seen this year, challenges often bring volatility, which in turn can create investment opportunities that we will continue to exploit. By holding liquidity, we are well placed to exploit opportunities that do arise. Holding this high level of liquidity also means that we can allocate remaining capital to higher yielding and therefore potentially more volatile parts of the market without significantly increasing the overall risk of the funds. Some of the key areas of the market where we continue to find opportunity include subordinated bank capital, subordinated insurance bonds and the telecommunications sector, where bonds are benefitting from ongoing merger and acquisition activity.

Financials - Julien Eberhardt

Our largest sector allocation in corporate bonds remains financials. Before thinking about the prospects for the sector in 2019, I think it is helpful to reflect on what has happened to financials over the course of 2018. At the start of the year, the financial sector was very popular with investors owing to the sectors attractive level of yield versus other parts of the market. After a strong start, a series of exogenous factors began to impact on the sector in late January/early February leading to significant re-pricing as the market sought to reposition.

Alongside concerns over US interest rates, trade, the Italian budget and Turkey were: money laundering concerns within Nordic banks, uncertainty over the treatment of stamp duty in Spanish property transactions and whether or not banks should pay the charge, Deutsche Bank’s profit warning and a change in its CEO, Aviva’s threat to cancel preference shares it had previously described in marketing material as irredeemable, HSBC’s reclassification of £2bn worth of discount perpetual floating rate securities (DISCO bonds) to tier 2 capital – a move which saw the bonds lose around 20% of their value and the ECB’s commitment to not increase interest rates until at least summer 2019.

Despite all of this, fundamentals within the banking sector generally remain, in my view, good. Italian banks have continued to reduce the amount of non-performing loans (NPL) on their balance sheets. Meanwhile, asset quality within the banking sector has continued to improve. What the past twelve-months has done is to bring some value back into the market. Additional Tier 1 (AT1) bonds and Bank equity are now significantly cheaper and, in my view, offer value . From a top-down perspective, the sector should receive further support if the European Central Bank maintains its current path and starts to increase interest rates in 2019. But, Brexit and Italy remain two significant risks for the sector and are areas we are closely monitoring. As has been the case this year any further periods of volatility would, all else being equal, provide an opportunity to increase exposure.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

This article is marketing material and is not intended as a recommendation to invest in any asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.