Once the darling of bond investors as Fed rates tended towards negative territory, rising 10-year US treasury yield rates have seen investors take a second look at emerging market investment-grade (EM IG) bonds. Once a “best of both worlds” option with high yields at relative safety, duration risks, unattractive valuations and tight spreads have weakened their lustre.
“Given the firm performance of EM IG bonds in 2020, we believe that valuations relative to EM High Yield (HY) have become less attractive. EM IG also has a significantly higher duration relative to HY and therefore is more susceptible to the impact from rising rates, and finally the tighter spreads in EM IG also results in a smaller buffer against rising rates,” says Eli Lee, head of investment strategy at Bank of Singapore (BOS).
This prognosis comes amid a healthy US jobs report last Friday, with markets optimistics that good times are coming back. Higher inflation and economic expectations thus drove rock-bottom 10-year US Treasury yields to the lofty heights of 1.60%. The BOS economics team have moved their 12-month forecast for 10-year US Treasury yields to 1.90% on the back of bullishness on the US economy.
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Some investors are worried about rising field yields and its impact on the continued post-pandemic recovery. Lee reports that BOS has observed real yields move from -1.0% to about -0.65% in recent months. Yet such a trend, he comments, is typically driven by stronger economic prospects and will spell good news for equities, since higher growth in corporate earnings and falling equity risk premium outweighs the negatives of a higher discount rate.
“While real yields could rise further from here, they are still broadly at very low levels versus average historical levels. Despite its recent move up, the US 10-year real yield is still far below the S&P 500 earnings yield and the current differential is significantly above the average level from 1990 to the present,” reports Lee, who sees this as supportive for equities.
Nevertheless, while the rising yields will not derail the long-term post-pandemic bull, market turbulence may persist in the short-run as inflation figures rise from a low base. Lee’s base case is that a predicted mid-year spike in inflation will likely be temporary. Structural forces like technological disruption and demographic changes will act as a counterweight against inflation.
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“Our view remains that the Fed will not taper QE in 2021 and will not hike until 2024,” pronounces Lee, who notes that his base case reflects Fed thinking.
For equity markets to bottom out decisively, says Lee, markets must put away their fears of inflation and bond market volatility. The odds of this happening improve as yields rise, with the Fed likely to pour cold water on rising yields as they approach 2% to ensure an orderly recovery. Markets are also pricing in excessive interest rate hikes, with investors expecting the scenario of one 25 basis point hike in 2023 and at least three by end-2024.
In any case, liquidity remains abundant, with excessive deposit accumulation in US banks now near record levels. Lee sees this as a source for continued demand for bonds. Banks are obliged to match the duration of their liabilities even as balance sheets expand due to strong quantitative easing measures from the Fed and subdued loan growth. Further liquidity is expected as congress moves to pass a US$1.9 trillion fiscal stimulus by mid-March.
