Good morning!

One of the most controversial topics over 2014 and so far in 2015 has been the timing of the first interest rate hike in the US and the negative implications of such movements for the US government prices (UST). In 2014, such bearish forecast were somehow shattered by markets as the 10 year US sovereign yields fell from 3% to 2.2% while the 2 year rate, which is more sensitive to the central bank’s policy, had a more volatile year and closed the year notable higher.

In my opinion this divergence reflects the particularities of the current global environment as the long term yields were kept at bay by (i) the fall in yields in Europe, (ii) concerns that the global economy might be in for an extensive period of sluggish growth (which in turn implies a slower and more restrained increase in Central bank rates) (iii) geopolitical conflicts supporting demand for safer assets (iv) money printing in Japan and (v) fears that some commodities are undergoing structural changes implying lower inflationary fears for longer.

Since these factors are yet to unwind, I refuse to read too much into the projections which point towards a sizable rise in the 10 year yield by year-end; after all at end-January the consensus was seeing the latter reaching 2.8% by end-2015 while now the forecasts are pointing towards a target of 2.6% from 2% at the moment (Bloomberg surveys).

If these projections turn out to be accurate, the long term USD corporate bonds would come under pressure although the total returns should be supported by the decrease in spreads (the gap between corporate and government spreads) which started off lately.

The next question is whether the short term corporate bonds are a better alternative. As I touched upon in the beginning, a potential increase in Fed’s key interest rate (which is an overnight interest rate) will have a more material effect on the shorter term yields (up to 5 years). In my opinion, at this juncture such a change in policy is possible in the later part of the year with risks skewed towards a delay.

There are many variables that can alter this viewpoint among which a pickup in consumption on account of lower fuel prices and higher employment. The reality is that what we are experiencing nowadays is hard to fit into the traditional forecasting models; this year will be marked by exceptional money printing in Europe and Japan, while the fall in commodities is taking a toll on global inflation and on the commodity-leveraged economies (Canada, Australia, Norway, Russia, Brazil to name a few) pushing them to ease their monetary policy.

Indeed, even the Fed’s President seems to prefer retaining flexibility without taking an excessively accommodative standpoint. Just yesterday, she stated “Provided that labour market conditions continue to improve and further improvement is expected, the Fed policy committee anticipates that it will be appropriate to raise the target range of the federal funds rate when, on the basis of incoming data, the committee is reasonably confident that inflation will move back over the medium term toward our 2% objective.”

As such, I would see as more opportune positioning into medium to longer term corporate bonds (i.e. over 5 years) as the persistent volatility at the short end might make the returns unappealing on a risk-adjusted basis. Of note, such a positioning should in my opinion outperform as well in the event that the Fed decides to hike its rate because the spread tightening for the 5-7 years segment should outpace the movements in government yields. This is particularly relevant for high yield companies which in most cases see higher spreads for this time bucket reflecting uncertainties on their financials over the medium term and the general perception that over the longer run the companies can address the challenges they face. Relatedly, interest rate hikes usually coincide with lower spreads because the improvement in economic growth which brought such a change in policy eases investors’ concerns.

Very sensitive to the monetary policy outlook are as well the bonds issued by financial companies as interest margins charged by banks should improve as rates increase. Indeed, just looking at the spread of the USD Investment Grade Financials and the US Treasury 2y rate early this year, a negative correlation emerges. It would thus be advisable in my opinion to overweight non-financials unless one is confident that a change in Fed’s policy is soon to come. In any case, a new wave of regulatory requirements announced last year should increase the supply of financial paper.

To conclude, in the current environment where the pace of US growth remains comfortable but not particularly strong, I see scope for going overweight5-7 years high yield bonds, with a tactical preference for single B rated names in view of their underperformance over the last few months (two names that are likely familiar are Sprint and KB Home). However, in order to align the rating of the portfolio with the risk profile of the investor, an allocation to IG non-financials is warranted.

Have a nice day!