It has been a year of surprises in fixed income. You wouldn’t know it by looking at the year-over-year change in bond yields. We’re virtually back to where we started on U.K. and U.S. ten-year government bonds, but the journey in between has felt at times like being on a roller coaster.
One spectacular example was the normally staid ten-year Bund. After dipping within touching distance of negative yield in April, it reversed precipitously when crowded trades unwound. In a span of just 12 days, plummeting prices wiped out more than 60 years’ worth of income, leaving the Bund with its biggest rout in total return terms since 1994. Here’s our checklist of what to expect in 2016, and what it means for insurance fixed-income portfolios.
Divergence will be the dominant theme in the coming year. Not just divergence among central banks’ monetary policies but also between developed-markets and emerging-markets growth; between global services and manufacturing sectors; and, finally, between the U.S. and European credit cycles. All this divergence is manifesting itself in the market: U.S. and German two-year government bonds were recently trading at their greatest spread in nearly a decade.
As the Bank of England and the Federal Reserve move to tighten financial conditions and raise interest rates, in contrast to further easing from the European Central Bank (ECB), the Bank of Japan and the People’s Bank of China, powerful cross-currents will be set into motion in global foreign exchange rates and the shape of fixed-income yield curves.
Meanwhile, government bond yields will continue to be supported by admittedly mediocre long-term growth and low but steady inflation expectations. China’s slowing economy will weigh on the global economy but not derail developed-markets growth. Inflation will continue to be dampened by excess global spare capacity, although it should start to pick up more in the U.K. and the U.S. in 2016.
Divergence breeds volatility — a fact of life that investors will have to accept this coming year. Both structural and temporary factors are fueling volatility. Liquidity in fixed-income markets is lower as a result of a fall in dealer balance sheets caused by higher capital charges. And idiosyncratic risk is picking up as we move farther along in the credit cycle in the U.S. and Europe.
When we think about the impact of all these factors on government bonds, what matters for the markets will be the pace of Fed normalization and the terminal rate — which will surely be lower than in past cycles. Our expectation at J.P. Morgan Asset Management is for the federal funds rate to get to 100 basis points by the end of 2016, and 200 basis points by the end of 2017 — or, in other words, a real rate of around zero percent, assuming 2 percent inflation. The strength of the U.S. dollar and inflation will have a big impact on how this plays out. Government bond curves should flatten over the hiking cycle, with long-end yields not much higher than where they currently are.
In terms of insurance portfolios, we are a bit reluctant to take a directional duration view. Instead, we prefer to look at curves and cross-markets. The change of shape in the yield curve will also impact our short-duration property and casualty portfolios differently from our life insurance portfolios. Given the attractive risk-adjusted returns for insurers, Italian and Spanish government bonds are among our highest-conviction investment views. We expect spreads to tighten a further 30 to 40 basis points from current levels.
Let’s now turn to corporate credit. In the U.S. there are already signs of late-credit-cycle behavior, such as an increase in the number of M&A deals and share buybacks and record issuance in the debt market. In comparison, balance sheets in Europe are in much better shape, and the macro backdrop is also constructive. ECB quantitative easing and a weaker euro should help with exports, and low oil prices should help with input costs on the industrial side, further strengthening corporate borrowers.
For investment-grade credit, we think 2016 will be a carry year, with limited tightening in spreads, given the amount of supply expected and a deterioration in fundamentals. There is potential for total return, in addition to income, in the European high-yield market, which is attractive versus other core fixed-income alternatives — even on a capital-adjusted basis — for insurance companies. A key driver in our allocation for insurance portfolios is the attractive risk-adjusted carry. There is still room for compression of high-yield spreads versus investment-grade corporates.
For insurance company fixed-income portfolios, maintaining diversification to take advantage of divergence will be critical in the year ahead. Where risk appetite permits, insurance investors should investigate allocations to sectors such as high-yield corporate credit and U.S. dollar–denominated corporate credit, hedged back into pound sterling and euro. It will also be important for insurance investors to really know the risks in their portfolios — stress testing and modeling the risks of a rising rate environment will be key.
Prashant Sharma is a managing director, portfolio manager and head of international fixed-income insurance at J.P. Morgan Asset Management in London.
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