Knowledge. Shared Blog

October 2019

Finding Value in Bonds Amid Negative Rates

Jim Cielinski, Global Head of Fixed Income, provides his perspective on some of the key macroeconomic factors that are driving fixed income markets.

Key Takeaways

  • The U.S. yield curve is a good indicator of recession when accompanied by other factors such as a weak consumer, a decline in inflation, falling jobs or weak employment. However, with few of these signs  present, the curve appears idiosyncratic at this juncture.
  • Negative-yielding debt has soared to roughly $15 trillion worldwide. This is not merely a symptom of weak economic growth, but is also due to insufficient demand and excessive debt loads, as well as central banks falling short with their policy toolkit.
  • Against this backdrop, investors may question whether bonds still have a place in their portfolios. While their income component is clearly diminished, we believe bonds still play a valid role as a source of diversification, particularly in risk-off markets.
View Transcript

Is the U.S. Yield Curve still a reliable indicator that recession is coming?

Jim Cielinski: I think the U.S. Yield Curve has been overhyped as a recession indicator. It is a great indicator when accompanied by other things, like a weak consumer or let’s say falling inflation, falling jobs or weak employment. We see none of those, and so I think you have to look at the curve and say it is a little bit idiosyncratic in this particular phase.

On top of the weak inflation expectations, the weak growth expectations, we know what the toolkit for central banks is and it is often buying more bonds, lowering rates. And these things I think when you look at it in conjunction with those economic variables are really powerful in depressing the yield curve.

Will the ECB’s pursuit of negative rates be effective, or is it time for fiscal policy to pick up the stimulus baton?

Cielinski: The markets are telling us that fiscal policy must come to the rescue. The ECB will do what it has to do, it will pull out the same bag of tricks that it did in the last cycle and that is just because they can’t do anything else within their remit. Will it be effective? I doubt it. It wasn’t that effective the first time. And negative rates have some, I think, really bad side effects. The bank profitability issue, that credit creation function which originates in the banking system is broken and actually gets even more broken with negative rates. And ultimately, that is what you need to get the economy out of this weak spot.

How did we arrive at $15 trillion of negative-yielding debt worldwide?

Cielinski: It is astonishing that we are looking at so much debt that has a negative yield. This has been 30 years in the making, so it is not just a symptom of weak growth today. This is insufficient demand and excessive debt loads that when combined, you just don’t see the credit creation needed in today’s economy to send rates higher. And so with central banks falling short with their policy toolkit, I think it is the combination of all this, that has led to negative rates. These are structural in nature, so it is difficult to see these suddenly reversing except on a short-term cyclical basis. So it seems quite odd, but as long as those conditions stay with us, negative rates will stay with us as well.

What are the implications for market liquidity as highly accommodative monetary policy returns?

Cielinski: Easy money is often associated with more liquidity, but I think it is important to realize that is in the economy. With markets, what that often means is that central banks distort markets. They, through quantitative easing, buy a lot of the supply. And in fact, that reduces market liquidity.

Now it is important to remember that does not mean markets always go down, illiquid doesn’t mean weak markets. Illiquid can also mean rising prices just as that buying distorts markets and pushes prices higher. But I think market liquidity remains very challenging in the coming year. You are going to have these volatile spikes in the market, both up and down. Be ready for those, but don’t overreact. I think it is quite easy to have fear overwhelm your decision making in these periods. but most of these you should really wade through and ask, “Is it a true shift in fundamentals or is it a market liquidity event?” If it is the latter, stay calm.

Given the landscape, do bonds still have a place in investors’ portfolios?

Cielinski: When I look at the valuation of bonds today, it is hard to argue that zero gives a lot of upside potential. That said, bond yields can move more negative and with that capital appreciation can still exist. But I think people do need to feel like their return expectations should be lower. So that is what I would caution people to look at and identify what they are in bonds for.

Historically, it has been about income and it has been about portfolio diversification. With low yields, I think it is fair to say that income component is quite low. You can still see it in some places though, emerging market debt, corporate debt, high yield. And with low default levels, that may not be a bad place to hang out to get that income. But the return potential is more limited.

That said, I have heard for years that bonds didn’t have any diversification potential left and when you do get risk-off environments, bonds rally. So I still think they serve that purpose. And I think with that, you start looking at the appropriate outcomes of different fixed income products and you will find when you do that most fixed income products still have a very valid role in a broader portfolio.

Download 4Q Global Fixed Income Compass

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