The policies and pure rhetoric of various central banks have dominated the interest rate markets so far this year. Interest rate markets are now divided into two central bank camps and at best are fairly valued. In credit bonds, some segments are looking expensive and investors must focus on selectivity and security.
There is a clear group of countries, such as New Zealand, the US and the UK, that are moving towards “rate normalisation”. Interest rates are expected to normalise and the only outstanding question is on the timing and speed of rate hikes. These countries exhibit steeper yield curves in the two to five-year range.
On the other hand, there is another group of central banks that are pursuing a wait-and-see or stimulatory policy – including the Bank of Japan and the European Central Bank. For these, where further stimuli is likely, the yield curves are very flat in the range of up to five years.
What both groups have in common is that the longer-term and implicit forward interest rates are no longer cheap following this year’s interest-rate rally. We expect the market prices for both groups to continue to react very sensitively to any subsequent central bank statements in coming months.
In credit bonds, risk premiums have fallen further. Demand for new issues remains vigorous and investors are increasingly making compromises to access a little additional yield. At the same time, some market segments and borrowers are, by historical comparison, rather expensive with risk not fully reflected in valuations.
This applies to, amongst others, short-term high-yield bonds in dollars and euros, various industry segments in the investment-grade corporate sector, and some emerging markets issuers. In addition, expanding M&A increases the possibility of event risk.
Although there is no reason for a withdrawal from credit bonds, some profit taking on expensive positions or the building up of a partial hedge should be considered. In this environment, investment decisions should be made on a very selective basis, with selected financials and industrials continuing to present profitable opportunities.
Bernhard Urech is head of fixed income interest rates and Christof Stegmann is portfolio manager of fixed income credits at Swiss & Global Asset Management