John Pattullo, Co-Fund Manager of Henderson Diversified Income Trust, explains how the suppression of volatility by the US Federal Reserve during the Covid crisis has led to the Japanification of the US corporate bond market.

 Key takeaways:

• Just as we saw in Europe, Japanification — which refers to Japan’s experience of persistently low interest rates, low inflation and low growth and where the central bank has completely supressed volatility — has now spread to the US and, at a remarkably faster pace.
• As was the case in Japan, the US central bank’s suppression of volatility, together with its backstopping of investment grade (and, to a lesser extent, high yield) bonds, has created an almost idyllic environment to invest in corporate bonds.
• With the collapse of the sovereign yield curve in the US, there have been large inflows into the US corporate bond markets in recent months, with overseas buyers as the major participants. Interestingly, given the unending search for yield, quality, well‑known investment grade names are now almost the new sovereign bonds or the new benchmark rates.

Note: this video was recorded on 14 August 2020.

Video transcript

I thought I’d give you a brief update on our team’s thinking.

Now, HSBC coined the phrase ‘the decade of denial’, which really is the lower for longer, lower inflation, lower growth and lower bond yields, which many people deny, especially in America, less so in Europe. We’ve been of that view really from 2013 when we started speaking about Richard Koo’s [from Nomura] secular stagnation thesis. Now the Covid crisis, we didn’t anticipate, nor the oil crisis. But of course, we are not surprised by the direction of travel of bond yields. We are a little surprised by the pace of travel.

Japanification has spread to the US

Now, the Japanification of Europe was a big theme and that’s played out well for us and for our investors. We think that’s really spreading and has spread to the American corporate bond markets. If you look at Japan, what the central bank has really done is completely suppress volatility. That is almost ideal, an idyllic environment for investment grade corporate bond investing. Compounded by the [US Federal Reserve] Fed backstopping investment grade and, to a lesser extent, some high yield default risk with the purchase of corporate bonds in investment grade and high yield. You combine that with a massive, almost a desperate search for yield — you know, I’ve been doing this for 20 years now and all I’ve really heard, is give me reliable, sensible yield.

Unusually big inflows and fairly limited inventories

So, what we’ve seen is a lot of supply and Nick [Ware] has written a recent article saying that bond glut has really been moving to a bond drought and that’s a topical piece. The suppression of volatility, the underwriting of systemic risk, and investment grade is really a systemic asset class, driven by VIX volatility and to a lesser extent, default probabilities.

In addition, you’ve had big inflows, as I spoke about, and fairly limited inventories in the street and overseas buyers have been a big participant in the American corporate bond markets; because as interest rates have come down, the hedging back to local currency costs have come down. So actually, we think corporate bonds in America are actually pretty cheap in a relative, international, scale and that desperation for yield, we think, will only continue. Look to Japan, the evidence is in Japan, the suppression of volatility, lower MOVE and VIX indexes suggest volatility has been suppressed by the central banks. That’s a great environment for corporate bond investing.

In some ways, the quality, sensible income names are really almost the new sovereign bonds, almost the new risk free rate. Well‑known names are almost the new sovereigns, the new benchmark reference rate, because the sovereign curve has completely collapsed. This is exactly what we saw in Europe and is exactly what is playing out in America and, if anything, it is playing out remarkably fast. But still, we think some people remain underweight bonds and the flows are really massive and almost terrifying, even though I’ve been doing this a long time.

Recent thoughts and research from the team

Finally, I’d like to highlight some of the research the team has recently done. I wrote a piece, ‘So what about inflation?’ And I think people shouldn’t confuse inevitable, cyclical, uptick in bottlenecks and price volatility in commodities and lumber and gold and copper — a cyclical breakout — with a secular or structural shift; and that will probably be the debate next year. I mentioned Nick’s article ‘From bond glut to bond drought’, and then Jenna [Barnard] and Nick have also written a new piece recently about the break in the link between GDP declines and default rates.

Default rates in America will be higher because the constituents of the index are generally worse and there are less government bailouts. Whereas in Europe, we think default rates might actually be quite low — zombification of names but massive government support. Germany, for example, has put almost three billion [euro] via various agencies into TUI. They put nine billion [euro] into Lufthansa and, there’s a lot of socialisation of risk in Europe, unlike in America. And that’s an interesting divergence.

So, to summarise, we remain pretty bullish. Corporate bond spreads, they have come a long way, but that suppression of volatility, like what happened to Japan, is the main point.

Thank you very much for listening. If you’ve got any thoughts or questions, please contact your local salesperson. Thank you.

 

Note: the government bailout of Lufthansa amounted to US$9.9 billion, or €8.3 billion at the 14 August exchange rate.

 

 

Glossary

Bond: A debt security issued by a company or a government, used as a way of raising money. Bonds offer a return to investors in the form of fixed periodic payments, and the eventual return at maturity of the original money invested

Commodity: A physical good such as oil, gold or wheat. The sale and purchase of commodities in financial markets is usually carried out through futures contracts.

Corporate bond: A bond issued by a company

Cyclical: Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.

Default risk: the risk that a lender takes on in the chance that a borrower will be unable to make the required payments on their debt obligation.

Hedging: taking an offsetting position in a related security, allowing risk to be managed. These positions are used to limit or offset the probability of overall loss in a portfolio. Various techniques may be used, including derivatives.

Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.

Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high-yield bonds.

Sovereign bond: Bonds issued by governments and can be either local-currency-denominated or denominated in a foreign currency. Sovereign debt can also refer to the total of a country’s government debt.

Systematic rick: “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry

Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment

Yield: The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.