Portfolios: Mon Pol Normalization Not Ending Search For Yield

By Yali N'Diaye

     OTTAWA (MNI) - While rising yields will challenge fixed income portfolio

managers going into 2018 as central banks from advanced economies reduce

accommodation and global growth strengthens, the expectation of moderate and

gradual interest rate moves will continue to pressure portfolio managers to

search for yield outside the sovereign space to deliver returns.

     That being said, a growing sense that risk assets have reached stretched

valuations and that inflation could still create an upside surprise that could

accelerate monetary policy tightening is keeping fixed income asset managers on

the cautious side, leading them to limit their duration risk and to climb the

credit quality ladder of corporate bonds.

     So far the search for yield has already translated into tight credit

spreads and high equity valuations, reducing the attractiveness of high yield on

a valuation basis.

     Yet, "carry trade will remain a key investment theme," Natixis Asset

Management Fixed Income Strategist Axel Botte told MNI.

     He cited diminished political risk in the euro zone, supportive growth

conditions, ample liquidity in the financial system, improved credit quality,

low and declining European high yield default rates, and European Central Bank

quantitative easing among supports for the ongoing search for yield.

     "The risk-free yield increase is likely to be modest relative to past

experience," he argued, as ECB President Mario Draghi is keeping a dovish tone.

He added that so far, upside surprises on the growth side have not penalized

bond markets all that much. And inflation "is unlikely to spark a selloff in

2018," while scarcity issues in core markets are keeping a lid on yields,

leading Botte to slightly favor peripheral markets.

     "Bund yields are anchored by scarcity and fiscal surpluses in Germany,"

with net issuance expected to fall next year, Botte told MNI, adding the asset

manager is holding "a slightly long tilt in favor of peripheral bonds."

     Country-specific developments are also favoring peripherals, said Botte,

who expects Portugal to be upgraded in December, for instance.

     In addition, "Portugal will be less affected than other markets by tapering

since purchases of PGBs are much less than capital key level," which is used to

allocate the share of bonds the ECB can buy from each country based on the

respective countries' population and GDP.

     Spain should also be upgraded despite a more uncertain timing related to

developments in Catalonia, in Botte's view.

     And in Italy, a new electoral law has added visibility to the political

landscape.

     So "even if valuations appear unattractive in parts of the credit markets,

chase for yield will remain an investment theme," Botte told MNI.

     "Carry will be supported as long as monetary policy remains highly

predictable and market volatility low," he added.

     While "fat-tail risks have been reduced" in peripheral countries, Botte

said, "core spreads offer little value versus benchmark Bunds," with French

spreads "somewhat expensive."

     He expects ECB asset purchases to end in the fourth quarter of 2018, while

the Federal Reserve continues its normalization process. This combination and

the Bundesbank maturity choices should intensify the steepening pressure, in his

view. As a result, he expects spreads with the U.S. to widen up to intermediate

maturities but to remain stable around 200 basis points for the 10-year.

     At BTS, where the approach is quantitative, a correction in high yield will

likely be considered as an opportunity to reset prices at more attractive levels

that would help the bond portfolios reenter the high yield space from money

markets.    

     Citing signs of an upcoming weakening in the high yield market - increased

volatility, outflows from high yield into investment grade bond funds, as well

tight spreads - BTS Asset Management CEO Matthew Pasts estimates that a spread

widening event "to more realistic valuations" has a "strong probability" of

happening over the next several weeks or couple of months. 

     That would bring back buying interest, including his own, given the low

default environment and supportive growth conditions.

     While expecting monetary policy tightening and yield increases to be

moderate, NN Investment Partners Multi-Asset Senior Strategist Pieter Jansen

agreed in a commentary that "given the turning point in the monetary policy

direction, tight valuations and weak liquidity, the risk of a temporary,

moderate spread widening is material."

     He is nonetheless looking out for opportunities by trying to combine short

duration and spread compensation from higher risk assets. He is especially

looking at convertible bonds, alternative credit and emerging market debt.

     Roger Bayston, senior vice president and director, Fixed Income, Franklin

Templeton Fixed Income Group, also stressed in this week's Beyond Bulls & Bears

commentary that "markets have been in a prolonged period of exceptionally low

market volatility and I expect there could be heightened volatility in this

coming year."

     While supply factors in the U.S. market as well as technological

disruptions in the economy keep him cautious, he underlined the "solid

underlying fundamentals of the U.S. economy" that leave him open to

opportunities in the credit space.

     He is also playing down U.S. politics headlines, which he sees as a source

of short-term volatility and "noise" rather than a factor changing his

fundamental view.

     Overall, the low default rate outlook as well as stronger growth prospects

are definitely leaving portfolio managers open to some risk taking in higher

risk fixed income despite the more cautious approach.

     However, Bank of America Merrill Lynch pointed out that high yield outflows

have reached nearly $10 billion ($9.8 billion) over the past four weeks,

including a $2.0 billion outflow in the November 22 week, when IG bond funds

recorded a $4.3 billion inflow.

     This reflects Loomis Sayles Global Bond Fund Co-portfolio Manager Lynda

Schweitzer's approach.

     Within developed markets, the Fund is defensive on G3 rates - U.S., Japan,

Europe - due to expected upward pressure on yields over the next 12 months,

seeking returns outside government bonds.

     "Corporate fundamentals are expected to remain solid given our economic

backdrop so even though spreads have tightened over the last 18 months, we still

like the extra yield versus Treasuries," she has told MNI.

     But as a sign of caution, the portfolio manager favors investment grade

over high yield across the three markets.

     Yet, and even as its Bull & Bear Indicator is now close to a sell signal,

BofAML is saying "stay long risk assets until sentiment reaches euphoric

territory of 8.0" from 6.8 currently.

     Year-to-date through November 21, Bank of America Merrill Lynch estimates

that European high yield has been the biggest winner in fixed income with an

18.7% return, even topping U.S. equities (+18.4%).

     U.S. corporate high yield only comes number 9 among fixed income categories

with a 6.9% return.

--MNI Ottawa Bureau; +1 613 869-0916; email: yali.ndiaye@marketnews.com

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