“Game Over” for Treasury Bonds

Amid falling real rates, we continue to favour Treasury-Inflation Protected Securities (TIPS). It is crucial to know that it’s not necessary to see an increase in the Consumer Price Index (CPI) for TIPS to rise in value. Indeed, it is just enough that inflation expectations, such as the Breakeven rate and the 5y5y inflation swap forward rate, rise to make TIPS a compelling investment, despite the negative yield they are offering at the moment. Exchange-traded funds that can give exposure to TIPS are iShares Barclays TIPS Bond Fund (TIP) and PIMCO Broad U.S. TIPS Index Fund (TIPZ), as well as the iShares USD TIPS UCITS ETF (TPSA) for euro investors.

Long duration: the only game in town for European bondholders

Austerity is a word that was erased from the vocabulary last year as governments across Europe issued more debt in the wake of the Covid-19 pandemic. By the third quarter of 2020 Germany had increased its debt by 14% from the beginning of the year, while France had increased debt by 12.4%. As tighter lockdown measures are imposed in the first quarter of this year, we can expect more stimulus from European policymakers, making European sovereigns a compelling buy opportunity. Furthermore, a combination of ECB policies and the Recovery and Resilience Fund (RRF) will support the economy as government stimulus begins to fade in the second half of the year. Not only that, but the RRF could also be seen as contributing to the creation of a more robust and united economic bloc, which could boost sentiment in the periphery. 

Investors should not be discouraged by historic low European yields, as capital appreciation will continue to be the only game in town for all of 2021. In particular, sovereign yields of the periphery will continue to narrow relative to those of Germany.

Italian BTPs are poised to benefit the most from monetary and fiscal policies as they trade rich compared to their peers. The spread between 10-year BTPs and the Bund will most likely fall below 100bps to tighten as much as 90 bps. It will result in 10-year BTPs (IT0005422891) yields falling to 0.4%, representing an upside of around 1.5% for bondholders. Unlike US Treasuries, long duration will play in favour of bondholders in the European space. Thirty-year BTPs (IT0005398406) could go up as much as 10% as the spread between 30-year BTP and the Bund falls below 120 basis points. 

Duration will favour government bonds in Europe as a whole, benefitting ETFs such as the Xtrackers II Eurozone Government Bond 25+ UCITS ETF (DBXG) and the Xtrackers II Eurozone Government Bond 15-30yr UCITS ETF (DBXF). 

Percentage gain/loss according to a given movement in yield

Source: Bloomberg and Saxo Group.

The beginning of a new era for the United Kingdom sees upside for inflation-linked government bonds

Although Gilts in 2020 offered protection against the volatility provoked by the Covid-19 crisis and Brexit noises, this year they will suffer from an identity crisis. On one side there are expectations of an economic rebound due to the rollout of a vaccine and a Brexit deal; on the other we have tighter lockdown measures imposed in the wake of a third Covid-19 wave, and the uncertainty of how the British economy will fare without the European bloc. As a consequence, sentiment in Gilts will remain mixed before finding a proper direction. A neutral stance will be the most appropriate strategy for the first quarter of the year. At the same time, it is important to monitor how the economic backdrop develops. A large part of the market expects a rate cut from the Bank of England that will push nominal yields lower, but if inflationary pressure arises, it will be unlikely that the BOE will embark on this journey, leaving yields free to rise. 

The indisputable trend that we will witness in the sterling bond space will be a steady fall of real yield. Higher nominal yields will not match higher inflation expectations, as policymakers will try to keep borrowing costs lower for longer to kickstart growth. In this context, it is crucial to reduce weight on nominals and enter inflation-linked bonds, or ETFs which track inflation such as the Lyxor ETF iBoxx U.K. Gilt Inflation Linked (GILI).

Another way to reduce the risk of falling real yields is to buy higher-yielding security. However, sterling spreads have tightened below pre-pandemic levels, meaning that credits are more expensive than a year ago despite carrying higher default risk. Rather than buying into a single name, investors could consider entering in high-yield corporate ETFs such as the iShares Global High Yield Corp Bond (GHYS), in an effort to ensure diversification.

Green bonds will continue their rise

Governments and corporates are expected to issue $500bn in green bonds this year, which is more than double the amount issued in 2020. Governments will be inclined to increase investments in this sector, as studies have found that green infrastructure investment creates more jobs than other traditional investments. 

Green bonds represent the perfect opportunity for investors to diversify their investments into a new sector about to flourish. It is particularly true for euro-denominated green bonds, as interest rates will remain low for longer. Regarding US dollar-denominated green bonds, investors should cherry-pick and beware of duration, as already explained above. At the moment, corporate green bonds offer a pickup of around 80 basis points over their benchmark both in the United States and Europe, which unfortunately doesn't give enough protection against rising yields in the US.

Sovereign Bond ETFs 

Source: Bloomberg and Saxo Group
*Table shows 5-year total return or since inception

Energy bonds to benefit from reflation

The recent wave of Covid-19 cases has slowed down economic activity, disrupting demand and prices for crude oil and fuel once again. Although the market is fast in envisioning a renewable era, the transition to green will be gradual, and in the foreseeable future we will still need to rely on the traditional energy sector. Thus, a considerable part of investments will need to continue to flow to sustain existing energy supply levels. Governments will need to continue to support struggling energy companies through stimulus packages to ensure that there will not be disruption to economic activity. Once the economy is on a stable path to recovery, we can expect energy demand to be restored and the sector to recover quickly.

The bond market offers many opportunities within this space; however, it is crucial to cherry-pick. Energy companies with a contained net debt to EBITDA will be able to weather depressed energy demand spurring from low economic activity. At the same time, state-owned companies will be better positioned to take advantage of stimulus packages. In a previous analysis, we found exciting opportunities within Lukoil, Gazprom and Ecopetrol, which offer competitive yields for their notes. On the other hand, while Pemex offers one of the highest yields in this sector, the company is poised to suffer together with Mexico's government bonds from a massive debt burden, and a dependency on the capital market to service its debt.