Although the fundamentals of the global economy remain healthy, equity markets around the world have been much more volatile in 2018 than in the last few years amid rising Fed rates, normalizing global monetary policies, escalating trade frictions and increasing geopolitical uncertainty.
In October, global stock market indices suffered their worst monthly performance in nine years, triggering a broad selloff in almost every asset class.
During our latest client call, Lan You, Global Investment Specialist, J. P. Morgan Private Bank, and Ben Sy, Head of Fixed Income, Currencies and Commodities for Asia, J. P. Morgan Private Bank, discussed why investors may consider investing in bonds now and how to build a bond strategy in a volatile market.
History indicates that bonds can help protect downside risk as well as diversify a portfolio in either an up or a down market. The recent bouts of late-cycle volatility in global stock markets have underscored the importance of holding bonds as a fundamental building block in any portfolio.
- Bonds are becoming increasingly attractive to investors amid volatile stock markets and rising interest rates.
- As we move into the later stages of the current economic cycle, investors may invest more in bonds to hedge against risks from equity holdings and provide a source of stability in the portfolio.
- At the current stage in the cycle, investors may consider investing in high-quality, short-duration and floating-rate debt securities.
- The impact of the Sino-US trade frictions on Chinese bonds might be limited, but it is important for investors to select larger issuers with higher ratings and robust financial positions.
Why invest in bonds now?
Nine years into the global economic recovery, major central banks, led by the Federal Reserve (Fed), are finding themselves on the path to normalizing their long-standing ultra-loose monetary policies that have inflated global asset prices. Considering the strong fundamentals of the US economy, we expect the federal funds rate, which has risen to 2.25% from zero two years ago, to move up further to 3.25% by the end of 2019 as the unemployment rate continues to drop and wage growth picks up in the United States. Against this backdrop, short-term bonds are becoming increasingly attractive to investors.
Following a long recovery from the 2008 financial crisis, the US economy might grow more slowly than it did in the past decade, but in our view the imminent onset of a recession is unlikely, at least within the next year. But as we enter the later stages of the economic cycle, bond assets may become increasingly attractive to investors and play a more important role in their portfolios. After a significant rise in yields, safer bonds with higher ratings are starting to offer competitive returns relative to other assets.
Allocate more to bonds as the cycle matures
Stocks and bonds tend to respond in opposite directions to fluctuations in investor risk appetite. While that has not necessarily been the case this year, we believe the negative correlation between stocks and bonds might become increasingly obvious as we enter the later stages of the economic cycle and, further down the road, as we head into the next recession. Fixed income assets are generally considered an essential part of any diversified investment portfolio and high-quality bonds, in particular, can provide an important buffer against volatile stock markets.
While no one can predict exactly when the next recession may hit, we are likely to see greater volatility in various types of risk assets as interest rates move up in this late-cycle environment. In this context, it would be important for investors to dial down risk in their portfolios by gravitating towards the more defensive parts of the market.
Less is more, be selective
While many believe bonds are not a good place to invest when interest rates are rising, we do not agree. From a long-term perspective, higher rates are good for the returns of a bond portfolio over the next five to ten years. In the current cycle of interest rate normalization, we believe investors might gain some exposure to short-duration and floating-rate debt securities to avoid the opportunity cost of sitting on cash and to lock-in higher returns. Currently, short-duration bonds are trading at reasonable valuations that already price in much of the potential upside in interest rates over the next one to two years. Moreover, floating-rate notes are well placed to protect investors from Fed rate hikes by offering higher yields in a rising rate environment.
As the economic cycle matures and interest rates continue to move up, investors may extend the duration of their debt holdings over time. For example, we may now allocate to bonds with a three- or four-year duration and then move to a five- or six-year duration by mid-2019 if interest rates, especially the long-end of the curve, continue to march higher. As the economy moves further into recession, the upward trend in interest rates will likely be reversed, making high-quality bonds even more attractive.
At this point in time, we think it advisable for investors to focus on investment-grade, high-quality debt securities. High-yield bonds are unique in the fixed income landscape due to their high correlation with equity markets, and they tend to perform well when economic indicators start to stabilize. Having suffered a sharp correction this year, valuations of Asian high-yield bonds are looking more attractive than they were at the start of the year. Considering the weak demand for such bonds and a potential increase in supply we believe the valuations of Asian high-yield bonds may come down further to more reasonable levels by the first quarter of 2019.
Trade frictions and issuer selection
We think the current trade frictions between the US and China will cause some pain to Chinese consumption and economic growth, especially in 2019. A slowing economy could lead to an increase in corporate defaults and bankruptcies, heightening the risk of losses to bond investors. That said, we believe the overall impact from the trade conflicts on Chinese bonds might be limited. Considering Asian high-yield issuers are mostly Chinese property developers, housing sales and prices are of greater importance to their leverage and cash flow.
So our view is that it is crucial for investors to mitigate the risk of their bond investments through rigorous issuer selection. Below are some considerations which might be taken into account:
- Property developers: We suggest investors select larger issuers with higher ratings and robust financial positions, as such high-quality developers could gain larger market shares during industry downturns. State-owned issuers might receive greater support from the government and banks and hence may come with lower risk of default than privately-owned issuers. However, investors might be careful to differentiate between different types of state-owned issuers and select the potential beneficiaries of China’s pro-growth policies.
- Local government financing vehicles (LGFV): Investors might select LGFVs that are created to raise money to fund real economic activities with higher ratings and healthy financial conditions, and be cautious about those without real economic activity or lacking a direct and clear relationship with local governments. Meanwhile, it is also important for investors to evaluate various LGFV bonds in terms of costs versus rewards.
- Perpetual bonds: Since issuers of perpetual bonds normally have superior credit quality and ratings, investors might focus on managing the risk of interest rates associated with such bonds by comparing the interest rate reset features and structures of different issues and credit spreads. It is worth noting that in an environment of rising interest rates, perpetual bonds that pay a fixed coupon throughout its duration might have much greater downside risk than those with attractive coupon reset features.
Having read these views, if you would like to talk about a suitable strategy for your bond portfolio please contact your J.P. Morgan representative.
This material is for information purposes only. The views, opinions, estimates and strategies expressed herein constitutes the judgements of Lan You and Ben Sy based on current market conditions and are subject to change without notice, and may differ from those expressed by other areas of J.P. Morgan. This information in no way constitutes J.P. Morgan Research and should not be treated as such.