Corporate bonds the asset of choice for low growth

The market had become somewhat over-optimistic on growth, in the wake of a long and drawn out announcement of QE3. While earnings expectations had lost touch with reality, those expectations have recently come crashing down as a result of the following series of events and announcements:

• Earnings were worse than the elevated expectations had predicted
• Expectations on key equities, like Apple, had become over exuberant
• US elections re-focussed the market on the possibility of a fiscal contraction in 2013
• European growth has continued to falter

Hence, the idea of a growth breakout, and the consequent bond crash, as expected by some, especially those pushing high risk asset allocations to clients, have proven incorrect. In questioning the idea of a bond crash, this piece does two things.

• First it reviews the macro-economic environment, where recent Fed commentary is considered, along with recent IMF warnings on growth. Both tell a very consistent story; do not be complacent on growth, so the outlook for growth is one of continued volatility, which will prove challenging for equities.
• Second, we suggest an asset that suits this macro-economic outlook; corporate bonds. In this challenging environment for growth a low risk asset class, which does not sacrifice return, is probably the best way of proceeding. 

Fed commentary – missing employment and economic growth targets

While the US Federal Reserve (the Fed) has two major goals, price stability and full employment, Williams, from the Federal Open Market Committee (FOMC) provides a good summary of the current situation below,

Let’s start by considering the goals Congress has assigned us: maximum employment and price stability. What exactly do these concepts mean? Let’s start with maximum employment. Now, maximum employment does not mean a situation in which everybody is working. Instead, economists think of it as the level of employment that the economy can sustain over time without inflation rising too high. Economists fiercely debate what the unemployment rate would be under maximum employment. Typical estimates are between 5 and 6 percent. Thus, by almost any credible measure, the current 7.9 percent rate is much higher than we would get at maximum employment.

What about price stability then? Fed policymakers have specified that a 2 percent inflation rate is most consistent with healthy economic growth and our mandate from Congress. So where are we? Inflation has averaged only 1.7 percent over the past year, below this 2 percent target (“The Role of Monetary Policy in Bolstering Economic Growth”, Presentation to the University of San Francisco, Center for the Pacific Rim, By John C. Williams, President and CEO, Federal Reserve Bank of San Francisco, For delivery on November 14, 2012).

In other words, officials at the Fed are indicating that they are undershooting on both goals; inflation is too low and employment is too low. While the economy might be close to the point where the Fed might tighten, the communications strategy from the Fed is much more advanced from where it was in 1993, just before the crash, as Yellen recently observed,

To fully appreciate the recent revolution in central bank communication and its implications for current policy, it is useful to recall that for decades, the conventional wisdom was that secrecy about the central bank’s goals and actions actually makes monetary policy more effective. In 1977, when I started my first job at the Federal Reserve Board as a staff economist in the Division of International Finance, it was an article of faith in central banking that secrecy about monetary policy decisions was the best policy: Central banks, as a rule, did not discuss these decisions, let alone their future policy intentions. While the Federal Reserve is required by the Congress to promote stable prices and maximum employment, Federal Reserve officials at that time avoided discussing how policy would be used to pursue both sides of this mandate. Indeed, mere mention of the employment side of the mandate, even by the mid-1990s, was described in a New York Times article as the equivalent of “sticking needles in the eyes of central bankers” (“Revolution and Evolution in Central Bank Communications,” Remarks by Janet L. Yellen, Vice Chair, Board of Governors of the Federal Reserve System, at Haas School of Business, University of California, Berkeley, Berkeley, California, November 13, 2012).

Now the Fed is keen to use better communication to increase the effectiveness of policy, so that if we did get close to the need for a tightening, then the Fed would be much more open to the market than it was in 1993, just before the bond crash of 1994. 

IMF analysis – warning that global growth remains precarious

Recently, the International Monetary Fund (IMF) has issued a document that illustrates the many risks that face advanced economies. This is not just a routine warning; it is a warning to the members of the IMF that global growth is precarious for many important reasons. In particular, the IMF estimates that most countries will be experiencing slow growth as a result of further European stress, as the below figure indicates. It looks like the question is not whether Europe will impact global growth more than it already has, but how much more. Importantly, the current level of policy uncertainty is not helping the current situation, as investment is being held up, until some clarity on the direction of the economy is provided (IMF, Group of 20, Global Risk Analysis, Annex to Umbrella Report for G-20 Mutual Assessment Process, Prepared by Staff of the IMF, p.4). In addition, the IMF note the following:

• While growth is recovering, the recovery is “fitful” with variations in member countries apparent
• Even though global financial conditions have stabilised, financial stress has re-emerged
• European crisis management activities are proceeding, yet the dampening impact of fiscal austerity on growth, is apparent
• One of the areas of acute concern to the IMF is the deleveraging by Euro area banks, which is amplifying the fiscal austerity measure in the system
• Peripheral European governments are experiencing reform fatigue, and this may threaten current reform procedures

In terms of the risks to growth, the IMF see that world economic recovery remains highly vulnerable, with Europe remaining in a “danger Zone” (IMF, Group of 20, Global Risk Analysis, Annex to Umbrella Report for G-20 Mutual Assessment Process, Prepared by Staff of the IMF, p.5). While one might have thought that the European crisis was already over, the IMF are actively looking at the prospect of what an intensified Euro Crisis might mean for the various regions of the world. As the Figure 1 below indicates, the impact of further problems in Europe will be widespread, including most of Asia, Australia, and the United States.

Figure 1
Source: (IMF, Group of 20, Global Risk Analysis, Annex to Umbrella Report for G-20 Mutual Assessment Process, Prepared by Staff of the IMF, p.7).

In addition to all of these concerns, there are two other major problems for global growth:

• A contraction in the US, due to the need to reign in debt, is also seen as very real threat to global growth, and
• Geopolitical tensions in the Middle East, which may lead to another spike in oil prices, which may dampen global growth.

More recently, the OECD supported the more cautious approach of the IMF with further revisions of growth, and warnings about the risks to growth, as follows,

After five years of crisis, the global economy is weakening again. In this we are not facing a new pattern. Over the recent past, signs of emergence from the crisis have more than once given way to a renewed slowdown or even a double-dip recession in some countries. The risk of a new major contraction cannot be ruled out. A recession is ongoing in the euro area. The US economy is growing but performance remains below what was expected earlier this year. A slowdown has surfaced in many emerging market economies, partly reflecting the impact of the recession in Europe (Editorial, The policy Challenges: now and in the long term, p.4, OECD Economic outlook 92, Press Conference, Paris, 27 November, 2012, Angel Gurría Secretary-General & Pier Carlo Padoan Deputy Secretary-General and Chief Economist).

Corporate bonds: close to equity return with half the risk

In the above risky environment of low growth, and possibly rolling recession, one should select an asset that provides return in a format that is reliable, and corporate bonds fit that role well. Specifically, investment grade corporate debt yields more than government debt because the corporate debt has slightly higher credit risk. This is not to say that all the 3 to 5 year corporate securities are weak credits; the cut-off for inclusion in the index is BBB-, or equivalent for all the three main ratings agencies (the lowest investment grade credit rating), and the issue size needs to be A$100m. The market capitalisation weighted average credit rating for this index is currently considerably above the BBB- limitation, roughly AA-; although the credit composition may vary over time. We use a fixed maturity index in order to reduce the variation in the in modified duration of the index, so that we obtain a fairly constant amount of interest rate risk, over the period used for analysis. Also, the index is very useful in that it provides a broad indication of corporate bond performance and is not impacted by the fortunes of a single security.

Corporate bonds: return and risk characteristics

As Figure 2 shows, corporate bonds offer quite competitive returns, relative to equities. In particular, notice the steady positive stream of rolling annual return, compared to the erratic and turbulent history for equity returns. While there have been some negative returns, they are few and far between.

Figure 2

By taking marginally more risk than the composite bond index, the corporate bond investor enjoys a consistently competitive stream of return, even relative to equity return, and Figure 3 shows that corporate bonds can beat equities in a lot of cases, in terms of rolling annual return. Specifically, Figure 3 shows that corporate bonds provide better annual returns than equities almost half the time, over the period from 1990 to 2012, using daily observations, which is the UBS longest data set that is available at this time. 

Figure 3

Not only do corporate bonds achieve attractive returns, as they average over 90% of the annual average equity return, they do it in a way that is far less variable, or risky, than equities, with just under 40% of the average annual risk, or variation in return, as shown in Figure 4 below. 

Figure 4

By breaking away from the typical analysis, which typically refers to the composite bond index, we are then able to see the true benefit of corporate bonds, relative to equities. Not only does corporate debt make the lion’s share of equity return, corporate bonds do it in a way that is much more effective, when analysed from the perspective of annual risk. Not only do bonds do a great job on return and risk, they also mature, unlike equities. So, instead of having a perpetual exposure through equities, the bond exposure allows for a regular re-setting of investment return, if conditions were to change. As we have said before, equities appear set to add risk to portfolios, not return, while the opposite is the case with corporate bonds, in an environment where a bond crash remains a distraction, rather than a serious consideration. While sellers of equity risk and products are quick to trash prospects for the bond market, and while we would not respond by doing the same for the equity market, the prospects for bonds seem to us to be much more solid, when compared to equities at this point.

Conclusion

Bond crash talk is, in our view, highly premature; a distracting sideshow adopted by a private sector incentivized to sell risk products, and which is not adopted by recent official commentary. Importantly, such discussion fails to appreciate what the Fed has now done in terms of improving communication with the bond market. In other words, the discussion of a “bond crash” is not only alarmist, it is unhelpful to those who need to seriously focus on the asset allocation that will reach investment goals in the most effective manner possible. Such alarmist discussion is all the more misleading in the context of most official commentary, which is extremely conservative on growth, and which continues to highlight the risk that growth will be lower for longer. While the Fed thinks employment is too low, it also hastens to add that inflation is too low.

This is hardly the stuff of a bond crash.

If anything, this type of commentary is much more supportive of weaker growth and better returns in bonds, when compared to equities. While recent IMF warnings support the case made by the Fed, the recent annual return data in Australia points to bonds taking back the lead, in terms of annual return. Despite the ongoing tussle, between bonds and equities, in terms of annual return, the greater certainty of a bond biased portfolio seems fairly clear. In this environment, it should be possible for Australian government ten year bonds to make more fresh lows in yield, as part of this ongoing narrative; of low growth, low inflation, and a local equity market struggling to come to terms with such a situation. Bonds are not only here to stay, they will remain able to provide relative certainty for many years to come, and those who are warning of a “bond crash” are generally of little assistance in setting overall portfolio asset allocation.