US Treasury Bonds: A Ticking Bomb

Government bonds performed particularly well in 2020 as central banks and governments around the world provided extensive political support to households and entrepreneurs amid an unprecedented income shock. This year will be a challenge for bondholders as negative central bank real interest rates on the one hand reduce downside risk in the tail of the spread, but on the other hand they minimize risk premiums.

About the Author

Althea Spinozzi, Marketing Manager, Saxo Bank. She joined the group Saxo Bank in 2017. Althea conducts research on fixed income instruments and works directly with clients to help them select and trade bonds. Due to his expertise in leveraged debt, he focuses particularly on high yield and corporate bonds with an attractive risk-to-return ratio.

In the first quarter, investors will have to prepare for two possible scenarios. Either the market will still need new incentives to cope with the next wave of Covid-19 infections, or the strong economic recovery will force the authorities to gradually cut back on economic stimulus. While the first scenario is likely to be a repeat of last year, a strong recovery and a gradual withdrawal of fiscal stimulus by governments will leave weaker companies exposed to rising inflation and higher interest rates. Unfortunately, in both cases, the fatigue of the policy makers' material may lead them to make a mistake for which the bond market will pay. 

Be sure to read: How to invest in contracts for treasury bonds [Guide]

The only way to protect yourself from political misstatement and rising inflation is through coupon income while reducing your exposure to nearly zero-yield debt instruments. As real rates continue to decline, bond duration and low nominal yields will prove toxic, while higher yields such as junk bonds and emerging markets will be able to provide an adequate buffer until the economy returns to equilibrium; careful selection of individual instruments will be essential. Likewise, inflation-protected securities will prove to be an important tool to protect against rising inflation despite negative yields. Promising opportunities in the corporate area will apply to ESG sectors (Environmental, Social, and Corporate Governance) and energy due to the pandemic's focus on sustainable development and growing inequalities, and the recovery will favor energy demand.

US Treasury Bonds: A Ticking Bomb

In the light of the adopted last year by Federal Reserve the "Average Inflation Targeting" (AIT) approach, the likelihood of political error is particularly high. In this context, the Fed has committed to restraining the growth in nominal yields even in the event of inflation exceeding the target value. This means that although the Fed's monetary policy will limit short-term yields, market sentiment will shape the longer end of the yield curve. Long-term nominal yields may increase rapidly, as was the case at the beginning of the year after the Democrats took control of the Senate. As the market prepares for a bearish rise in the yield curve, the value of bonds will fall sharply, with coupon yields mostly paying off. Treasury bonds, unfortunately, still offer the lowest yields in history, offering no protection against an increase in profitability and exposing investors to significant losses. 

Since the mid-70s, treasury bonds have ended the year with a negative return only four times. In 2021, this could be the fifth time in more than forty years. The longer the maturity, the higher the potential loss for investors. For example, if US 50-year government bond yields end the year with an increase of 4,7 basis points, investors would suffer a loss of around 50%. If the 10-year government bond yields also increased by 20 basis points, the loss of investors would exceed XNUMX%. We warn investors about the long duration of bonds in such an environment, which means the end of an era for funds investing in such bonds, such as iShares USD Treasury Bond XNUMX+ yr UCITS ETF (TLT).

In the context of falling real interest rates, we continue to lean towards inflation-protected Treasury-Inflation Protected Securities (TIPS). It should be emphasized that the increase in the value of TIPS is not dependent on the increase the consumer price index (CPI). It is enough that inflation expectations, such as the so-called breakeven rate (the level of inflation that should be achieved so that the yield on fixed-coupon and inflation-linked bonds with the same maturity is the same in nominal terms) or the inflation swap rate for 5 years in 5 years (i.e. in the five-year period starting in five years from today) will increase to make TIPS an attractive investment despite the negative profitability offered at the moment. Listed funds offering investments in TIPS include iShares Barclays TIPS Bond Fund (TIP) and PIMCO Broad US TIPS Index Fund (TIPZ) as well as iShares USD TIPS UCITS ETF (TPSA) for European investors.

Long duration: the only option for European investors

Austerity regime is a phrase that fell into the past last year as governments across Europe issued more debt following the Covid-19 pandemic. From the beginning of the year to the third quarter of 2020, Germany increased its debt level by 14%; in the case of France, the increase was 12,4%. As lockdowns tighten in the first quarter of this year, we can expect further fiscal stimulus from European decision makers, thanks to which European Treasury bonds will become more attractive for investment. In addition, the combination of the ECB's policy and the Recovery and Resilience Fund (RRF) will provide support to the economy as the effects of government stimulus wear off in the second half of the year. The RRF can also be seen as contributing to the establishment of a broader and more united economic bloc, which may help improve sentiment in peripheral countries. 

Investors should not be deterred by the historically low yields on European bonds, as capital appreciation throughout 2021 will be the only investment theme. In particular, the difference in government bond yields between peripheral countries and Germany will continue to narrow.

The Italian BTP will benefit most from monetary and fiscal policy as its prices are higher than other comparable European bonds. The spread between the ten-year BTP and the German Bunds is likely to fall below 100 basis points, perhaps even to 90 basis points. As a result, the 0005422891-year BTP yields (IT0,4) will drop to 1,5%, which for bondholders is an increase of around 0005398406%. Unlike US bonds, in the case of Europe, the long duration will be good for investors. The 10-year-old BTP (IT120) could gain as much as XNUMX% as the spread between the XNUMX-year BTP and Bunds fell below XNUMX basis points. 

The duration will favor European government bonds as such, to the benefit of funds such as Xtrackers II Eurozone Government Bond 25+ UCITS ETF (DBXG) and Xtrackers II Eurozone Government Bond 15-30yr UCITS ETF (DBXF). 

The start of a new era for Great Britain is the rise in inflation-linked government bonds

Although UK government bonds provided protection in 2020 against the volatility caused by the Covid-19 crisis and the Brexit turmoil, they are facing an identity crisis this year. On the one hand, economic recovery is expected as a result of the implementation of the vaccination program and the conclusion of the Brexit agreement; on the other hand, the lockdown has tightened with the third wave of Covid-19 and the future of the British economy outside the European bloc is uncertain. As a result, sentiment on British bonds will remain mixed until a clear direction is established. In the first quarter of this year, a neutral approach will be the most appropriate strategy. At the same time, it is important to monitor the development of events in the area of ​​the economy. Much of the market expects to cut rates by Bank of Englandwhich will translate into lower nominal yields, but in the event of an increase in inflationary pressure, such a decision of the central bank will be unlikely, and consequently yields will be able to grow freely. 

In the area of ​​British bonds, the indisputable trend will be the consistent decline in real yields. Higher nominal yields will not live up to higher inflation expectations as policymakers will strive to keep borrowing costs low for longer periods to stimulate growth. In this context, it is important to reduce exposure to fixed rate bonds in favor of inflation linked bonds or inflation tracking funds such as the Lyxor ETF iBoxx UK Gilt Inflation Linked (GILI).

Another way to minimize the risk of a decline in real yields is to buy securities with higher yields. However, UK bond spreads have dropped below pre-pandemic levels, meaning corporate bonds are now more expensive than a year ago despite higher risk of default. Investors may consider investing in high yield corporate bond funds such as iShares Global High Yield Corp Bond (GHYS) to diversify instead of investing in a single company.

Green bonds continue to rise

Governments and businesses are projected to issue $ 500 billion in green (green) bonds this year, more than double the 2020 level. Governments will be willing to step up investment in this sector as research has shown that investment in green infrastructure creates more jobs than other traditional ventures. 

Green bonds provide an ideal opportunity for investors to diversify their portfolios through exposure to a new sector that will soon start to appreciate. This is particularly the case for euro-denominated green bonds as interest rates will remain low for an extended period of time. In the case of bonds denominated in US dollars, investors should carefully select individual investments and pay attention to duration, as explained above. At this point, green corporate bonds offer an advantage of about 80 basis points over the benchmark in both the US and Europe, which unfortunately does not provide sufficient protection against the rise in yields in the US market.

Energy bonds will benefit from reflation

The recent wave of Covid-19 infections has slowed economic activity, again negatively impacting fuel and crude oil and fuel demand and prices. Although the market can easily imagine the coming of the renewable energy era, the green transition will be gradual and we will still have to rely on the traditional energy industry for the foreseeable future. A continued inflow of investment will therefore be required to maintain current levels of energy supply. Governments will need to continue to support struggling energy companies through aid packages to ensure that business is not disrupted. Once the economy is on a stable recovery path, energy demand can be expected to return and this sector will recover rapidly.

The bond market offers many opportunities in this area, but individual investments should be carefully selected. Energy companies with limited net debt to EBITDA will be able to cope with the reduced demand for energy caused by the slowdown in economic activity. At the same time, state-owned companies will be in a better position to benefit from aid packages. In the previous analysis, we saw attractive opportunities for Lukoil, Gazprom and Ecopetrol, offering competitive bond yields. On the other hand, although Pemex offers one of the highest yields in this sector, this company, along with Mexican Treasury bonds, will definitely suffer from the enormous debt burden and the dependence of this debt service on the capital market.