We expect the disinflationary effects of the COVID-19 demand shock will outweigh any inflationary effects resulting from supply disruptions. Disinflation will keep interest rates very low and there are now opportunities in fixed income. Investors will however have to venture away from their traditional investments.
Investors today are confronted with interest rates that will probably stay very low for years. Waiting for them to rise is simply not an option.
In this article, we propose a number of strategies for investors in an environment of ultra-low or negative interest rates. We have selected them using the following criteria:
Asset classes such mortgage-backed securities (MBS) or asset-backed securities (ABS) can offer investors a yield pick-up relative to traditional fixed-income instruments. In particular, agency MBS are the largest single sector of the global bond market, and therefore represent a vast opportunity set for active managers to add value.
Both MBS and ABS can also offer diversification benefits thanks to their return drivers. Unlike equities and corporate debt, which are largely tied to corporate balance sheet health, MBS and ABS are more closely tied to consumer credit fundamentals. This unique feature means they can provide return potential with low correlations to risk assets.
Corporate bonds have been heavily sought by investors as the “go to” asset class in recent years. Today they face challenges over the debt-to-earnings ratios on the stock of the corporate bond issuers. The part of the debt-to-earnings ratio which concerns corporate bond investors depends on the region:
While the hope was that corporations would take advantage of low QE-induced interest rates to pay down debt, they responded in quite the opposite way by refinancing existing debt and then borrowing even more. Admittedly, if the future brings Japanification (shorthand for weak growth, low inflation and persistent low interest rates), then high debt levels are not so burdensome.
The latest earnings season showed a continued deterioration in earnings before interest, taxes, depreciation and amortization (EBITDA)-to-interest expense coverage ratios in both regions, but they remain at historically high levels in the US and have been improving in Europe since 2016 (see Exhibit 1).
Exhibit 1: Debt coverage ratios are falling in both the US and Europe: Chart shows EBITDA-to-interest expense ratios for the US and Europe on a trailing 12-month basis through 2019
Data as at February 18 2020. Source: FactSet, JP Morgan, BNP Paribas Asset Management.
This follows a year of practically zero year-on-year earnings per share (EPS) growth alongside gains of nearly 30% in equity indices. This seemingly contradictory outcome was driven primarily by rising price-earnings multiples as recession and trade war fears waned, coupled with a declining discount rate as government bond yields fell. Analysts’ forecasts are for EPS gains of 7%-8% in 2020. Even if this turns out to be too rosy, we still anticipate a recovery in earnings growth and better coverage ratios.
European corporate bonds, however, are relatively more attractive. The European Central Bank will remain supportive of the corporate bond market and at least domestic-oriented corporate bonds should be able to generate enough earnings growth to satisfy investors.
With lower-for-longer becoming a permanent state of affairs, the appeal of emerging market (EM) debt will remain high for investors in many developed markets. We anticipate growth in China now recover this year (though the coronavirus outbreak will weigh heavily in the coming months), which should support a gradual recovery in trade within Asia.
There is plenty of scope for the Chinese government to support domestic demand if needed. With the US Federal Reserve on hold and generally benign inflation globally, EM central banks will be able to keep rates at current levels or cut them.
In light of these fairly benign conditions, we believe EM debt (sovereign) could offer decent spread compression potential, particularly at current valuations.
Successful strategies will require a willingness to venture away from traditional investments. This approach, along with select tactical allocations to take advantage of opportunities, should stand investors in good stead.