Corona is gridlocking economies and societies, but the fixed income investor is doing amazingly well.
1. Government bonds
The main driver in these special times for a fixed income investor is the steep drop in risk free rates. Especially the US Treasuries yield curve has dropped significantly. Earlier this year the Fed, the US central bank, reduced its key rates in two strikes to zero, in response to the corona crisis. Also, the longer end of the curve has dropped significantly. While at the start of the year the 10-year US Treasury quoted at approx. 1.80%, in the meantime it yields below approx. 0.60%. And as you understand, declining rates lead to higher fixed income prices.
The majority of our investments in fixed income is US Dollar denominated. Needless to say, the declining rates have been favourable to us.
We argued for quite some time that the US Treasuries were the only asset class on this planet still offering some real diversification, a perfect hedge against future calamities, which is exactly what happened during this corona crisis.
Also the longer end of the Euro curves has further declined, though less than on the other side of the Atlantic. The Euro-curves already quoted rather depressed, even at negative rates for the better rated
sovereigns, which can be found rather in northern Europe. Our investments in the Eurozone sovereigns logically carried a lower duration, about half the duration we hold in the US Dollar zone.
2. Corporate bonds
Corporate bond performances owe a lot to the bail-out without precedent by the central banks of this world as well as the global sovereign fiscal policies. The central banks’ massive liquidity injections globally and the relief funds released by governments lead to recovering equity markets after the initial drop. But also the credit spreads which peaked initially fell back importantly, whereby today they are almost back at normalised levels.
But these performances cannot be achieved without doing decent homework. We invest only selectively in corporate bonds. Clean balance sheets and strong free cash flow generation are key in our priority list. We do not invest in banks, energy companies, or debt laden balance sheets.
3. Inflation-linked bonds
A third driver we find in inflation-linked bonds. One third of our investments in fixed income are in inflation protected securities. As you do understand, nominal yields consist of two components: real yields and expected inflation. Well, the real yields are down significantly. Both in the Eurozone and in the US, the real yields now quote well below -1%. The expected inflation initially dropped significantly during the full outbreak of the corona crisis, but has recovered since to pre-crisis levels. Inflation-linked bonds have the characteristic to be less correlated to nominal bonds, especially the expected inflation component, as they are immune to inflation.
4. Currencies
A fourth and last driver is currencies. As already mentioned, just over half our investments in fixed income are denominated in the US Dollar. Until recently we were almost entirely hedged for a depreciating US Dollar against the Euro. The US Dollar has lost about 10% year-to-date against the Euro, and consequently was of no concern to us. In the meantime, by de-hedging, we implemented a net exposure of about one third of our fixed income investments to the US Dollar.
Going forward?
We like to refer to Bill Gates’ law: “Most people overestimate what they can achieve in a year and underestimate what they can achieve in ten years’ time or more”.
The questions we need to ask ourselves today:
· Do sovereign bonds still offer a decent diversification?
· Are corporate bonds a better hedge against future inflation?
· Are rising defaults upon us? And will these be rather sovereign or corporate defaults?
· Which society is more robust, the US or Europe?
· Will central banks inject liquidities forever in the financial system? And what does it imply for our investments? A vanishing risk premium?
· Is the current situation unique? Or have we been here before? How did we fare since World War II in monetary and fiscal terms?
For sure history never repeats, but it often rhymes.
We continue to monitor the markets and will communicate with you about further developments in due course. As always, we remain at your disposal to answer any questions you might have.
Yours sincerely,
The Management of CapitalatWork Foyer Group
