The Silver Bullet | The New Bond Vigilantes

Policymakers are hitting Covid with a triple punch: the upcoming vaccine, super-low interest rates and record-high fiscal stimulus. Risk assets have priced in a sharp V-shaped recovery: US stocks, global high yield spreads and industrial metals are back to pre-pandemic levels.

There are exceptions. Under the surface of macroeconomic data, many firms remain vulnerable and pay higher risk premia to borrow. The recovery appears V-shaped from the top, it is shaped as a K across sectors and countries. Thanks to loose refinancing conditions, however, most companies in stressed sectors – travel, transport, tourism – have been able to gather over a year of liquidity. With a successful vaccine, even those sectors could bounce back next year.

Against this positive backdrop, bond markets are sending a stark signal. Despite a Democratic administration likely to implement more fiscal stimulus, US 10-year yields remain below 1%. Are bond investors underestimating the chances of a stronger recovery – or has a decade of central bank QE pushed the last bond vigilantes to surrender?

As the year nears its end, we reflect on the lessons we learnt in 2020, and prepare for new challenges.

When we launched our Global Credit Opportunities Fund in 2016, we aimed at creating a strategy able to search for yield and alpha in fixed income, amid an environment of ever-increasing government and central bank influence.

Five years later, QE infinity has become a reality. High debt levels mean asset purchases are likely to stay. Credit has become a standard policy tool, with central banks buying investment grade and high yield debt directly as well as giving banks’ below-market funding linked to their lending activity to non-financial firms and households.

Today, we are deep into financial repression. $18tn of global bonds are negative yielding. Less than a tenth yields over 3%. Most savers have nowhere to hide and will be forced to swallow interest rates well below inflation. In some cases, governments may attack private capital more explicitly. The UK RPI reform will change inflation benchmark to the lower CPI rate, resulting in £100bn of savings for the HM Treasury – no refund for bondholders.

History shows us that record amounts of debt and inequality eventually end with higher taxes, higher inflation, debt restructurings – or worse.

The old bond vigilantes may be dead, as bond prices and rates volatility remain firmly controlled by central banks. The new vigilantes need to choose a different battleground. This year, we learnt that portfolio construction needs to be nimble and bar-belled, to take advantage of policy cycles which drive market prices and trading liquidity in a binary fashion. We learnt that risk-free assets no longer exist and that in tail events, these may move in tandem with risky assets, both driven by central bank actions. Most importantly, we learnt that active portfolio management pays off.

Searching for Value in the Yield Desert

2020 has been about a quick transition from euphoria in January, to panic in March, and back to a full recovery today. The Covid-19 vaccine regulatory approval and depletion remains the markets’ main focus. Following recent releases of the trial results, regulatory approval in the US and Europe should take place in December, and deployment in early 2021. With 90% efficacy, 40% vaccine coverage is required to bring Rt below 1 in most European countries, meaning the end of intermittent lockdown before summer. That said, central banks remain dovish: in December, the Fed and ECB will both increase asset purchases. A fiscal deal in the US is likely by end of January.

With this positive news, markets have erased most of the scars left by the Covid crisis, even though these still persist in the real economy. US equities are back at all-time highs, and high-yield spreads are back to pre-Covid tights. Put differently, benchmark indices no longer offer a Covid-19 discount. Positioning in risk assets is no longer short as it was before, albeit it is still far from pre-Covid levels, as many investors missed the March-May entry point. Still, there is much less cash on the sidelines.

It is time to be more selective and to pick positions and asset classes where returns are still positively convex and at least equal to the downside risk. Across asset classes, we favour credit and convertibles vs government debt, across geographies, we favour Europe and Asia to US assets.

Credit upside: re-opening sectors and convertibles. In credit, we still see attractive risk-reward in sectors linked to economic reopening and in convertible bonds. Cyclical sectors remain wide vs defensives. Hospitality and travel offer an extra premium and remain over 100bps wide vs defensives. Energy firms remain the widest, 250bps above defensives.

Within re-opening sectors, we focus on issuers with 9-12 months in liquidity and/or support of a relatively strong government.

Bonds of the major cruise lines like RCL, CCL and NCL offer a good bargain as the industry is very concentrated, barriers to entry are high and the companies enjoy high asset-to-debt ratios. Airlines are another area where we see a convex risk profile, although with less barriers to entry. Valuations remain attractive, while government backing often limits downside in some cases, like Finnair, Lufthansa or Air Baltic. Value remains in selected names in the hospitality sector, like Accor or in the automotive sector, such as Aston Martin.

Convertibles offer upside exposure to equities and credit spreads, with cheaper valuations – not being a direct target of central bank purchases. Tech names offer convexity via exposure to equity upside without much credit risk. However, large caps in tech are expensive, and we see more value in potential disruptors, also in light of potential anti-trust restrictions on big tech. We see value in non-staples US names like Etsy or non-US issuers such as Ali Baba and Mail.Ru. Convertible bonds of more cyclical issuers offer more efficient exposure to economic upside. However, we stick to investment grade or crossover names in cyclical sectors, to minimize negative convexity. For example, we see value in large national champions like Total and BP, and in Air Canada.

Government debt: boiling frogs. Low-yielding government debt remains supported by expectations of unlimited central bank purchases. Government bonds of Portugal and Spain now yield 0% on the 10y tenor, and BTPs are negative up to five years. US 10y trade still at record negative vs inflation expectations. A slowdown of central bank purchases, a small increase in inflation or a sudden focus of markets on the quickly deteriorating public finances of advanced economies are tail risks for which investors are now not compensated. Today, inflation levels are still low – however, the policy debate is gradually shifting towards fiscal dominance – with universal basic income and modern monetary theory as the extremes. While none of these risks is likely to materialise in the next few months, one of them may eventually appear over the horizon. Investors will either lose money quickly in a repricing or slowly against inflation.

Rotating out of the US. Europe and emerging markets tend to be more cyclical and lagged US valuations in both equity and credit. Moreover, the new Biden administration will quickly move away from the trade tariffs agenda pushed by Trump, meaning a weaker dollar is an additional tailwind.

In Europe, we are constructive on high yield spreads, which remain wider, especially at the lower-end of ratings. We also find alpha in the banking M&A theme, where we are long smaller banks which may be potential targets – as we have seen by recent discussion across BBVA/Sabadell in Spain and UniCredit/Monte dei Paschi/Banca Popolare di Milano in Italy.

In emerging markets, the Covid-19 crisis may uncover several fragilities. Central banks have responded by lowering rates and governments with more spending – a developed market response made possible by a very dovish Fed. But what would happen if the music changes? We stay selective and favour high-yielders with strong international support such as Egypt and Ukraine or corporates in cyclical sectors with strong balance sheets like Embraer. Local emerging markets appear more interesting. EM currencies are still 10-30% weaker vs the USD year-to-date, and foreign ownership of domestic bonds is on average 10 pp lower in 2020. A cyclical upswing is thus likely to bring flows back into the asset class. The Mexican Peso and the Indonesia Rupee remain our strongest conviction, given the relatively high beta to global growth and a relatively conservative set of policies. The Russian Ruble has potential for the strongest rebound, as fear of potential sanctions prevented a rally despite large external buffers, and oil is still well behind most risk assets. Recent political changes make us less negative on the Turkish Lira, and the Brazilian Real may benefit from a broad rise in commodity prices.

How do we build a portfolio across these assets and manage risk in this environment?

Besides asset allocation, there are two key drivers of performance from portfolio construction: convexity/drawdown management and sector/name selection. A barbelled anti-bubble portfolio of credit and cash can deliver better long-term risk-adjusted returns and offer more optionality to take advantage of market drawdowns, as we showed in our last Silver Bullet.

Spread dispersion within the EU and US high yield index remains well above the historical average, and almost at the highs. Compared to January, CDS indexes saw a substantial migration of issuers from spread levels below 200bps to more extreme levels. Tight index with high dispersion mean alpha opportunities dominate beta, and active management has an advantage over index tracking. Moreover, tight levels are favourable to short positions, which can’t be achieved via indexes.

Covid Debt: Who will Pay the Bill?

To offset the economic losses from the pandemic, governments in developed economies have announced record fiscal stimulus: 11% of GDP in Europe, 14% of GDP in the UK and 12% of GDP in the US.

This increase in spending has been funded almost entirely through governments issuing more debt. In total, developed economies will add between 10-20pp in debt to GDP in 2020, we estimate based on the IMF’s October WEO data. While some of this debt has been absorbed by the market, a significant portion may be financed directly by central banks. Markets are cheering on positive news.

But what is the endgame to sustain higher levels of public debt?

The best, but least likely, solution is for real growth to exceed fiscal deficits. This is likely to work in the coming years as growth bounces back and governments raise taxes. However, this strategy has proven to be unsuccessful over the past decades, as demographics and the forces of secular stagnation keep a lid on growth. As seen in the side chart, over the last 20 years, developed economies’ excess of real growth to fiscal balances, while volatile, has averaged close to zero. Or to put it simply: over the last 20 years, governments have not managed to grow their way of their debt.

To boost growth and productivity, developed economies would need disruptive reforms broadening education, increasing competition and rebalancing tax systems. We see the current US administration making an attempt at equalising effective tax rates, breaking up monopolies and getting spending to help the weaker areas of society, as Janet Yellen just discussed in her first speech as Treasury Secretary Nominee. We are hopeful, but skeptical, that democracy may overturn the interest of rentiers.

Wealth taxation is another solution, but unlikely to work by itself. We estimate that with a 5% “pandemic tax” increase on income and corporate tax, it would take 15-25 years to pay off the additional 2020 debt, all else being equal. This strategy is infeasible as, aside from the high political costs, we will likely have another recession in the next 15-25 years, during which tax cuts would be needed. The government may also choose to pay less interest, as the UK recently did by moving RPI bonds to a CPI benchmark, starting from 2030.

This leaves us with the last two solutions, both of which are negative to bond holders: inflation or restructuring.

Restructurings appear unlikely at this stage, in developed markets. Recently, though Italian PM Conte’s undersecretary floated the idea of cancelling debt issued during COVID, research by Ostry et al suggests that the maximum sustainable debt for advanced economies is around 180% debt/GDP, which is still materially above most economies’ post-COVID debt levels. A more likely alternative could include governments issuing very long-dated or perpetual debt with low coupons, using the proceeds to buy back higher coupon or shorter-dated debt. While this approach could reduce the NPV indebtedness and perhaps even lower interest costs, ultimately it’s a kick-the-can approach which won’t help reduce the debt burden materially.

Finally, we remain with the last and most likely solution to reducing debt: inflation. In past cases of high debt in developed economies, moderate inflation has been the most consistent driver of reducing indebtedness. This is especially true when higher inflation is accompanied by low levels of interest rates. Or put simply: when real rates are persistently negative. This was the case in post-WWII US, when a positive fiscal surplus was accompanied by higher inflation due to the removal of price controls and a continuation of war-time supportive monetary policies. On the contrary, following periods of high indebtedness in Canada and parts of Europe, higher nominal rates offset the benefits of higher inflation, leaving all the heavy-lifting to positive fiscal balances and higher real growth.

Pick your Bond Vigilante against Financial Repression

“Nothing is so permanent as a temporary government program” – Milton Friedman

The old bond vigilantes have surrendered. They are unlikely to come back any time soon, as central banks keep rates low and control yield curves in a global pincer movement. That said, value is increasingly disappearing from fixed income markets, and governments are starting to abuse their spending powers, inflicting negative real returns to savers. History shows financial repression is here to stay, and likely to get worse.

Eventually, something will have to give. Either central banks will have to let real rates normalise, which is unlikely, or currencies will pay the price. Against this backdrop, China appears on a much stronger footing, relative to developed markets – with PBOC being the only major central bank saving ammunition.

The bottom line is clear: investors in bond benchmarks will be forced into losses either slowly, with yields lower than inflation, or quickly, if rates or currencies re-price. To preserve capital and generate alpha in this environment, the lessons learnt from recent years are going to be increasingly useful. We would like to thank you all our investors for their trust and for partnering with us in these challenging times.