Bond markets have been testing the Bank of Japan’s (BoJ) commitment to maintain yield curve control by keeping yields on the benchmark 10-year note within 0.25% either side of zero. After that level was repeatedly breached during the week ending 17 June, the BoJ stepped in. The bank purchased a significant amount of Japanese Government Bonds (JGB) on top of the standard offer of unlimited daily buying that it uses to reassure the market of its commitment to the policy. The 10-year JGB yield touched 0.265 per cent on 17 June, marking its highest level since January 2016. We took advantage of this sell-off to take profits on part of our underweight.
In a far more rapid move than expected, the bond market tested the BoJ’s resolve on yield curve control: the September JGB futures’ contract, on which we ‘doubled down’ only a week ago, sold off, with a 20-25bp move higher in yields of the cheapest-to-deliver bond on June 15. As such, we took profits in our multi-asset portfolios on half our position, a move led by valuations and some concern that in the very short term, the Japanese (BoJ and/or Ministry of Finance) may row strongly against these moves.
Caution on interest rate risk
We remain fundamentally cautious toward duration risk broadly and Japan in particular. We hold an underweight versus our benchmarks in Japanese interest rate risk in unconstrained portfolios. We have also reviewed valuations of corporate credit, where we are consider we are closer to – but not quite at – spread levels where we might seek to turn more constructive.
Sentiment is poor
There has been a distinct March 2020 ‘COVID-feel’ to markets, with moves in nominal and real bond yields and weakness in major equities reminiscent of that time. Global growth optimism based on key sell-side surveys is at an all-time low, with stagflation fears at June 2008 levels. Unsurprisingly, the profit outlook according to fund managers is the worst since Sept 2008. Importantly, though, this is not the view of the analyst community, whose earnings expectations drive multiples. In corporate debt markets, early in the second week of June we saw the second biggest volatility spike ever, with large swings in volumes in key high yield exchange-traded funds (ETFs).
What is priced in corporate debt?
Sharp swings notwithstanding, it is notable that the deeply negative returns in credit have been chiefly duration led (about two-thirds of the move). Credit spreads have widened but OAS spreads are not at distressed levels across IG, HY or EM indices.
Also of note is that while the liquidity premium demanded by investors in corporate bonds (which often contains important (and leading) information for other asset markets), has increased, moves here have also been relatively contained. Our corporate debt specialists recently reflected that around 75bps of the current OAS spread can be attributed to the liquidity premium delivered to investors in high yield corporate bonds. We arrive at a similar figure when looking at the price-to-net-asset-value deviation of the most liquid US high yield ETFs. Investors have in the past demanded up to 400bps in periods of stress. Lastly, defaults and other measures of creditworthiness are at historically low levels. But these measures are backward looking and it is not entirely clear whether current spreads truly compensate investors for a deterioration in underlying credit risk under more challenging macro circumstances.
Too early to buy risk assets
From a relative perspective, looking at the equity risk premium against the credit spread, investment grade credit in particular appears attractively valued in both the US and Europe (though this is not the case in high yield). In our view, it is too early to dip into risk assets, but credit is a clear candidate for adding risk should our appetite increase.
Asset class views as of 15 June 2022
Disclaimer
