- Bonds play an important role in providing stability in an investment portfolio.
- By skilfully mixing shares and bonds, investors can improve their risk-adjusted returns.
- However, extremely low interest rates make it difficult to find the right fixed-income securities. If you want bonds that generate interest, you need to look at emerging markets.
At first glance, it seems paradoxical: interest rates have never been so low, and yet investors are piling into fixed-income securities. How does that work? And can bond investors even achieve a sufficient return to offset inflation?
First things first: interest rates on the credit markets have never been as low as they are now. Many government bonds from countries with good credit ratings and therefore low default risk – have been in negative territory for some time. This means that anyone who lends money to these countries receives no interest in return but must instead pay for the privilege. At the same time, more and more companies are successfully raising fresh capital on the bond markets and raking in money from investors. Investors who buy these bonds and keep them until the end of their term are definitely going to make a loss – and that’s without factoring in inflation.
The Federal Reserve’s abrupt U-turn is making bonds attractive again. As long as interest rates continue to fall, there is a chance of price gains.
The threat of a recession and political risks are putting a strain on the equity markets. Investors are looking for safe havens on the bond markets.
Continued central-bank pressure on interest rates
High demand for bonds has primarily been caused by the US Federal Reserve (Fed). Last year, it looked as if the low interest-rate phase in the USA had ended and rates had reached a turning point. Everything pointed to the Fed gradually raising interest rates. Sooner or later, calculations suggested, other central banks, such as the European Central Bank (ECB), would follow suit and start to raise their interest rates too. In such a scenario, existing bonds with low interest rates would have suffered losses, and so there was little incentive to purchase them.
In autumn 2019, however, everything suddenly changed. Faced with increasing financial risks on world markets, the Fed decided to make a small cut to interest rates at the end of July, with another cut following in September. Many observers assume the September cut will not be the last. The central bank will “act as appropriate” to support growth, Fed Chairman, Jerome Powell, said at the beginning of October.[1] And the Fed delivered cutting interest rates in October once again.
For investors, this kind of statement is often an incentive to stock up on securities with higher interest rates. In addition, bonds that have already been issued normally rise in price when the market rate falls. The same is true of securities with a negative yield, such as most German government bonds.
Some investors also feel that it looks like the long equity-market boom is faltering. Fear of a recession, combined with concern that many political conflicts are escalating, has put the brakes on many investors’ optimism. Rather than risking high losses, they would prefer to look for safe havens[2] – even if that means accepting negative interest rates.
Earn money on interest rates
But which are the right bonds to choose? Traditional government bonds from developed countries such as the USA and Germany offer a high level of security. However, investors don't earn interest from them. Investors who want their investments at least to offset inflation need to look for alternatives. There are opportunities to be found in emerging markets and in corporate bonds. The usual caveat applies: the higher the return, the higher the risk.
Many emerging markets surpass their reputation
Many emerging markets, particularly in Asia, have made rapid progress over the past few years and shown robust economic growth. Their prospects may have dimmed somewhat recently, but it looks like the greater susceptibility to risk they displayed in earlier years has been superseded by a phase of ongoing stability with comparatively high growth rates. These countries’ borrowing rates are, however, still significantly higher than those of major industrialised nations such as the USA and Germany.
That being the case, emerging-markets bonds denominated in euros merit particular consideration. These securities may not enjoy the same credit rating as developed-market government bonds but many of them can match European corporate bonds’ credit quality. Emerging-markets bonds still also carry a yield mark-up compared to developed-market issues[3] with similar ratings. “By purchasing bonds issued in euros, investors can avoid currency risks,” explains Roland Gabert, fund manager at DWS.
The market for euro-denominated bonds has also experienced strong growth over the last few years, meaning investors have a wide selection to choose from. “In 2019 alone, seven emerging markets issued euro-denominated bonds for the first time,” says Gabert. “This creates more opportunities for investors to diversify their credit risk.”
Hard-currency bonds reduce exchange-rate risk
Hard-currency bonds[4] are preferred.
Nonetheless, hard-currency emerging-markets bonds are generally issued in US dollars, which means there is greater choice of securities in this segment. Their prospects are also relatively promising. However, European investors in US dollar-denominated securities need to factor in currency fluctuations.
It's also a good idea to keep a watchful eye on government bonds. For example, Argentina is facing the ninth sovereign default in its history. And in Turkey, there are growing signs that the country will be unable to cover its debt repayments.
