Uncertainties keep bonds on must have list

After the US presidential election in November, investors had expected bond yields to trend higher on stronger growth and inflation pressures. In reality, US 10-year Treasury bond yields actually edged lower year to date as of end May. With short term interest rates expected to rise only gradually in the US over the next 6-12 months, Citi analysts see opportunities in selected bond sectors.

Short Term Rates to Slowly Rise

• Citi analysts expect a total of 3 rate hikes from the US Federal Reserve (Fed) in 2017. Outside of the US, most central banks in the developed and emerging markets are expected to remain on hold in 2017 as inflationary pressures remain manageable. (See "3. Interest Rates— Rising Slowly") Meanwhile, long term US Treasury yields are likely to remain range bound, dependent on expectations over the likelihood, magnitude and timing of US fiscal expansion.

What Does This Mean For Investors?

• Citi analysts believe that selected bond sectors that offer investors additional yield and strong fundamentals remain attractive. Given lingering political uncertainties globally (See "5. Politics—Greater Uncertainties"), mixed economic signals from the US and concerns over a China slowdown, high quality bonds continue to remain an important part of investors’ portfolios.

Selective Regional Markets Offer Value

• Higher relative yields, improved economic fundamentals and contained USD strength are likely to be supportive for Emerging Market Debt (EMD). While Citi analysts do not expect spreads to compress significantly, the higher yields are likely to help boost returns.
• In Latin America, Brazil and Mexico are favoured. While Brazilian assets remain under pressure amid increased political uncertainty and Standard & Poor’s (S&P) has placed its BB ratings on downgrade watch, Citi analysts view the weakness as an opportunity. This is premised on the political scandal not spilling over to the broader corporate sector. Citi's positive view on oil remains a key support while export sectors including metals/mining, aviation and pulp/paper could benefit from a weaker currency.
• Within Asia, India and Indonesia are Citi's preferred local markets. S&P recently raised Indonesia's credit rating to Investment Grade (BBB from BB+), citing the country's macro stability, fiscal discipline and increased resilience. The positive macro environment in Indonesia and relative currency stability may attract further inflows. Citi analysts also remain constructive on local India debt, despite the central bank’s surprise move to keep policy rates on hold in April. Improving fundamentals and attractive valuations are likely to support further outperformance.
• Moody's recently downgraded China's sovereign credit rating from A1 to Aa3 in May, bringing its rating in line with S&P's as well as Fitch's. The reaction in the Chinese bond markets was fairly muted. Within the market, Citi analysts prefer State-Owned Enterprises (SOE s) over high yield property developers.
• In Emerging Europe, Citi analysts believe that Russia's 9% yields appear attractive despite geo-political uncertainties. Though sanctions remain a deterrent for investments, any future removal would likely provide a positive catalyst for local bonds.

• Citi analysts continue to be positive on US Investment Grade (IG) corporates. Despite strong outperformance from last year’s oil price recovery, valuations still remain relatively attractive in the Energy sector. Basic materials such as chemicals and metals/mining also offer compelling value although performance is likely to be highly correlated to changes in commodity prices.
• Bonds issued by telecom companies have been negatively impacted by heavy new issuance, higher leverage, higher US rates, and ratings downgrades. However, Citi analysts believe that current valuations have largely priced in these concerns.
• Within Financials, the senior unsecured bonds issued by US banks are likely to benefit from higher US rates. Some relaxation of regulations under President Trump could also boost earnings later this year. Despite their higher valuations, Citi still favours US subordinated debt and preferred securities.
• US High Yield (HY) bonds have become more expensive as the sector has rallied year to date. However, fundamentals are still robust as US default rates fell for the fourth consecutive month in April. Citi analysts are still positive on the sector, as valuations compared to other bond sectors are still attractive.
• Corporate bond purchases by the European Central Bank (ECB) under its asset purchase program have driven prices of Euro IG and HY corporate bonds up and yields are now near record lows. Given expensive valuations and the possible tapering of bond purchases by the ECB later this year, Citi analysts have turned more cautious towards Euro IG bonds. They are also less positive on Euro HYs than before. In terms of sectors, Citi analysts continue to prefer core European Financials, which potentially offer higher yields than US banks and are expected to benefit from lower political uncertainty, better macro trends, recovery of earnings/profitability as well as stronger capital positions.

Key Takeaways

• Higher relative yields, improved economic fundamentals and contained USD strength are likely to be supportive for Emerging Market Debt (EMD).
• Within US Investment Grades (IG), the senior unsecured bonds issued by US banks are likely to benefit from higher US rates. US High Yield (HY) bonds have become more expensive as the sector has rallied year to date. However, fundamentals are still robust and Citi analysts remain positive.
• In Europe, core Financials are preferred as they are expected to benefit from lower political uncertainty, better macro trends, recovery of earnings/profitability as well as stronger capital positions.