Quality Emerging bonds and long dated US Treasuries, a barbell strategy for the next Semester


Fund Commentary
16 Jun 2017


In May, US activity indicators were disappointing while unemployment figures and average hourly earnings were strong. The Fed kept its monetary policy unchanged and made very few changes in its statement, saying that weakness in growth is expected to be transitory.

Market participants have fully priced a 25bp Fed Funds rate hike to 1%-1.25% next month. Moreover, the Fed is expected to hike one more time before the end of the year but, more importantly, may provide “soon” the details of how it will reduce its $4.5 trillion balance sheet during the second semester. Its securities portfolio could gradually shrink by year-end or early 2018.

In Europe, another strong set of data (GDP, employment, consumer sentiment and manufacturing activity) pointed to further acceleration in growth. Consumption figures continued to be strong and unemployment improved again last month at 9.3%. However, despite reaching its highest level since September 2013 at 1.2%, core inflation remained far from the ECB’s target. This suggests that the current policy will not be modified in the short term and that any decision on QE tapering will be very unlikely until at least Q4 2017.

In this context, the US Treasury curve flattened on less growth upside and subdued inflation expectations. The 2y US Treasury yield increased from 1.26% to 1.28% (+2bps), the 5y decreased from 1.81% to 1.75% (-6bps), the 10y from 2.28% to 2.20% (-8bps) and the 30y from 2.95% to 2.86% (-9bps). At the same time, the 30y inflation-linked Treasury yield stayed unchanged at 0.91%, leading to a slight decrease of the inflation breakeven from 2.05% to 1.96%. In addition, the 3 Month USD LIBOR increased from 1.17% to 1.21%. In Europe, the German yield curve steepened on better growth prospects with the 2y German yield increasing from -0.74% to -0.72% (+2bps) while the 5y & 10y decreased respectively from -0.39% to -0.43% (-4bps) and -0.32% to -0.30% (-2bps), the 30y increasing by 6bps to 1.16%. At the same time, the French 10y OAT yield outperformed by rallying from 0.83% to 0.73% (-10bps) following the positive election outcome. The Italian BTP 10y and the Spanish 10y bond yields decreased from respectively 2.28% to 2.19% (-9bps) and from 1.64% to 1.54% (-10bps) on reduced political uncertainties. On the credit side, the European iTraxx Main decreased from 67 to 62bps, its lowest level of the year, driven by the tightening of French corporate spreads, while the US corporate CDX index slightly decreased from 64 to 62bps. In Emerging Markets, the CDX 10y EM index decreased from 251 to 248bps (-3bps).


During the month, the Investment Adviser slightly decreased the weight of issuers whose weight was getting closer to 5% and those with expensive valuations: Siemens 2018, BNG 2019 and FCE Bank 2019. The Modified Duration remained around 1.3. In terms of portfolio diversification, the Fund held 35 issues from 34 different issuers.


During the month, the Investment Adviser took the decision to sell, either totally or partially, expensive high quality bonds (EDC 2018, Linde 2018, KfW 2021) and invest the proceeds into nominal US Treasuries maturing in 2027 in order to increase the modified duration of the portfolio in anticipation of a resumption of the yield curve flattening move. He also sold the remaining positions in short dated high grade bonds (Toyota 2017, Microsoft 2018). As a result, the average yield to maturity was unchanged at 2.2% and the modified duration climbed from 4.6 to 5.0 at month end. In terms of portfolio diversification, the Fund held 37 issues from 34 different issuers.


During the month, the Investment Adviser increased the weight of Arcelor Mittal 2025 and built a new position in Vnesheconombank (VEB) 2025, Russia’s development bank, in order to increase the average yield of the portfolio. In terms of geographical breakdown, the top 3 countries were Russia (17.2%), India (10.7%) and China (10.2%). The rating allocation was 57.6% Investment Grade and 37.8% Crossover (BB+ and BB). The breakdown of the portfolio in terms of market allocation was 91.5% Emerging Markets, 3.9% Developed Markets (i.e. Luxembourg/ArcelorMittal) and 4.6% cash. In terms of sector allocation, the Investment Adviser favoured Governments (38.0%) followed by Materials (23.1%) and Energy (12.6%). The modified duration stayed around 5.2-5.3 during the month. In terms of portfolio diversification, the Fund held 33 issues from 33 different issuers.


The Investment Adviser’s medium-to-long term global outlook on bonds will probably become less cautious in the second half of the year. Poor inflation on both sides of the Atlantic could lead to an unexpected move of government bond yields. The Investment Adviser does not believe that the Fed will be able to raise its Fed Fund rates while, at the same time, start shrinking the size of its balance sheet. In the short term, the decrease of US Treasury yields could continue despite a probable (but not certain) rate hike in mid- June. More importantly, US Treasuries become more and more attractive and they could be a top performing asset class in 2018, especially the long dated bonds as an inversion of the 10-30y slope cannot be excluded. As a result, any correction would be seized upon by the Investment Adviser as an opportunity to add positions for a medium-long term strategy. In Europe, Bund yields could increase due to less political uncertainties and increased pressure on the ECB to start normalizing its monetary policy on improved economic conditions and reduced risk of deflation. The Investment Adviser will continue to monitor closely the resilience of the global cyclical recovery and the evolution of high beta emerging markets in order to seize any opportunity to reinvest in these regions which, probably, still offer the best risk-reward profile and will remain supported by low defaults, attractive carry and low supply.

In conclusion, the best performing asset class over a short-medium term horizon is still high quality Emerging Markets but in a medium term perspective (2018 and beyond) investors should start building positions in US Treasuries.


The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 14/06/17 and are based on internal research and modelling.