Views from the M&G bond team, May 2021

In a special webinar last week, M&G’s fixed income team gave their views on global bonds. From inflation to company defaults and where to find a decent yield, here’s a round-up of their thoughts:

Richard Woolnough, manager of M&G Optimal income, M&G Corporate Bond and M&G Strategic Corporate Bond, believes inflation could be just around the corner…

“There have been several important changes over the past year. The first is a political move to the left in the US and in Europe. In the US, the Democrats tend to want to spend and tax in their quest for a more equal society, but the party recognises the need to spend first and tax later this time round. This puts us in a more inflationary and interventionist environment than before.

“In Europe, pressure brought about by the pandemic has resulted in communal funding and countries requiring economic help will be subsidised by other countries – another move to the left that is basically resulting in a transfer of wealth to the periphery. And this collaboration potentially makes the Euro a solid currency once again. It will be good for growth in the short term, and also put pressure on inflation.

“Then there’s the oil price, which briefly turned negative last year. The market dislocated, but the shock to the system made OPEC realise it had a challenge: the cartel had lost its discipline. The cartel reasserted itself and, if it becomes strong again and can control the oil price, that too will be inflationary.

“Finally, central banks are the most active they have been in years. But they need to escape the ‘zero bound’. Interest rates have been too low for too long and this means there is no room to cut any more. To get out of this situation they need to encourage inflation. Once it’s 2-4% - when you have high growth and full employment – then central banks can raise rates and escape the zero bound. If they don’t, they’ll have no tools for the next crisis.

“And all this, in my view, points to inflation being just around the corner. And inflation can be dangerous for bond investors.

“The good news is that corporate bonds are about fair value at the moment. The probability of default is low due to central bank intervention, so there is still room to make money.

“The quality of the corporate bond universe is also good. When you go through a crisis like we’ve been through, the weak credits go to the wall and the stronger credits are left. Also, companies change their behaviour – management are so scared and shocked they are now running more conservative balance sheets. That’s good news for bond investors.”

Jim Leaviss, manager of M&G Global Macro Bond, believes that for the first time in 20 years, there is the possibility that global growth rebounds enough for interest rates to rise.

“The market has priced in four hikes for US interest rates by the end of 2023. But is it likely the economy rebounds this much?

“Economic growth for the rest of this year is expected to be exceptionally strong, but there are some lingering questions. For example, to what extent will people continue to work from home? To what extent will global travel return? And the US is still far from full employment. So there will be a burst of economic activity, but does it justify the sell-off in government bond yields we have experienced?

“For the first time in 20 years, I think there is the possibility that global growth rebounds enough for rates to rise.

“With a few exceptions, we’ve had a trend of falling bond yields and falling inflation over the past 30 years. But we’ve also had aging populations demanding yield and safe assets – this won’t change. So demand for fixed income investments remains in place.

“We’ve also had the globalisation of global economy since the start of 2000s. This has kept inflation. Despite trade wars and Brexit, I think we are in a world where globalisation will still keep prices low.

“It doesn’t feel like these things will change dramatically in coming years. But with so much stimulus in play, we do need to be nervous that the inflation gene could come out of the bottle and scare bond markets.

“Some emerging market bonds are attractive and we are happy to be holders of some of these riskier bonds despite potential volatility in the short term. Emerging markets can be sensitive to US moves, but they have an elevated yield over developed markets.”

Charles De Quinsonas, deputy manager of M&G Emerging Markets Bond, which is on the Chelsea Core Selection, says emerging markets are one of the few areas with real yield on offer.

“Emerging market bonds are one of the few fixed income asset classes with real yield on offer.

“When we think about the outlook, we think about growth, central bank policy (that of the US in particular) and then local vs hard currency.

“In terms of emerging market growth, the IMF predicts it to be 6% in 2021 and it is expected to outperform global growth. But it will differ across regions and Asia remains the growth engine. Latin America, which has been hardest hit by covid, is expected to have growth in the mid-single digits, growth in the Middle East should be more muted and emerging Europe is in the middle of the pack.

“Inflation pressure remains contained for most emerging markets at under 5%. Current account balances are also favourable for the larger countries, but there are some fiscal balance sheet vulnerabilities as the fiscal deficit of emerging markets has risen.

“Mexico is our largest overweight. The Mexican president has not touched the fiscal side of things at the expense of the real economy, so it has experienced a sharp decline in GDP during the pandemic. But because of its close ties to US economy and the fact that it should benefit from both US fiscal stimulus and a US recovery, the economy should rebound from a very low base.

“When it comes to the US central bank, Fed rhetoric should mean a gradual interest rate hike cycle. And emerging markets are in a better shape than they were at the start of taper tantrum in 2013.

“Investment grade bonds in emerging markets have already gone back to pre-covid levels. High yield bonds – particularly those in dollars - still look attractive though.

“When it comes to local currency there are pockets of value such as the Mexican Peso and Russian Rubel, but we are more cautious on future returns as central banks will have to follow the Fed.

“So, at the moment, we have about one third of the portfolio in local currency, 20% in emerging market corporate bonds and the rest in dollar denominated sovereign bonds.”

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the fund managers and do not constitute financial advice.