The bond market bear has started to show its teeth, but this doesn't mean investors should ignore this US$100 trillion market, writes JP Morgan's Kerry Craig.

After a more than 35-year bull market in bonds, the surge in US Treasury yields earlier this year and again in April has put some investors on edge. The long-awaited rise in yields has finally arrived.

The initial surge in yields was bond markets re-pricing to reflect a stronger growth outlook for the year ahead and a faster pace of tightening from the US Federal Reserve. April saw another leg up in bond yields, this time driven by higher commodity prices and rising inflation expectations.

Since bond yields move inversely with prices, any significant hike in Treasury yields results in capital losses. The longer the duration of the bonds, the more interest rate sensitive they are – theoretically a 1 per cent change in interest rates would equate to losses of close to 12 per cent in price return on a 10-year Australian government bond at today’s yields.

All this highlights the clear need to be mindful of duration risk and potential capital losses on government bonds. However, investors shouldn’t necessarily baulk at the broader fixed income market, especially in an environment where the near-term threat of a recession remains low.

Economic conditions in the US and elsewhere in the world look robust for the coming 12 months, meaning that government bond yields should continue to march higher as inflation firms and the Fed continues to tighten monetary policy. But it also means that corporate balance sheets will be sturdy and default rates low.

Inflation at last

There is no doubt that inflation is firming in the US and the risks to inflation are on the upside thanks to the $400 billion in fiscal stimulus that the US Administration has announced. Core rates of inflation, excluding food and energy, jumped in March on a year-over-year basis, and are likely to stay higher.

This is largely because figures from a year ago were depressed by a string of seemingly one of events. In a series of weaker than expected reports from March to July 2017, inflation rates were depressed by the price of mobile phones, pharmaceuticals, airfares as well as lodging costs.

However, the Fed’s preferred measure of inflation, core personal consumption expenditure (PCE), was lagging a little at 1.6 per cent year-over-year in February. We expect that inflation will continue to simmer away and that core levels of PCE inflation will gradually rise to the 2 per cent target over the coming months, supporting further tightening of monetary policy by the US Federal Reserve.

However, government bond yields on a sustained path to higher levels is arguably a positive sign for the global economy. A modest 25 basis point increase in the US cash rate each quarter this year is completely palatable to markets.

We would expect this pace of rate increases to push the US 10-year Treasury yield to between 3 and 3.5 per cent by year end. To be greatly higher than this, a more sustained increase in inflation would be needed.

Investors should also bear in mind that 2018 is still a year of net bond buying by G4 central banks. The continued purchases by the European Central Bank and the Bank of Japan more than offsets the US$50billion a month in monetary tightening from the Fed. This persistent level of demand will act to cap just how far bonds yields can rise.

Credit: a non-recessionary asset

The current macro and micro environment is one in which a broad, diversified allocation to different segments of the credit market should deliver single digit returns for investors. This may not sound very exciting, but bonds aren’t meant to be.

Investment grade credit historically has not seen meaningful spread widening until entering the final stages of a rate hiking cycle. Since December 2015 the Fed has raised rates six times and there are another possible six hikes to come by the end of 2019. In other words, at best, we are only mid-way through the current cycle.

More importantly, underlying company fundamentals are robust. High interest coverage ratios across the sector and slightly higher interest rates should not deter companies’ ability to pay coupons. High yield companies exhibit a similar picture, with over 75% of new issue proceeds going towards refinancing.

A cautious outlook on government bonds and duration is certainly warranted, but investors shouldn’t abandon the fixed income market altogether.

We believe that even as yields on government bonds rise to 3 per cent, and a bit above, this really reflects the continued reflation and growth in the economy. This view is not without risks and a sharp move higher in yields would create market ructions. And we are conscious of the tighter spreads in credit markets, and aware valuations are no longer as attractive, which means anticipated returns are lower.

The government bond bear may be looking a little grizzly, but it hasn’t gotten its claws into the credit market.

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Kerry Craig is a global market strategist with J.P. Morgan Asset Management. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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