By Eléonore Bunel, Head of Fixed income management at Lazard Frères Gestion
After a general fall in interest rates in 2020 driven by central bank measures, 2021 has begun on a new footing. The return of inflation has pushed up long-term rates, while the anticipated return to normal has led to a decline in risk premiums.
Since the beginning of 2021, we have seen two opposing movements on the bond markets. On the one hand, long-term rates are now beginning to climb on the sovereign debt segment, both in Europe and in the US. On the other, we have seen a narrowing of spreads between safer, investment grade securities and riskier, high yield securities.
Sovereign debt: inflation part of the equation
There is an explanation for every phenomenon. Let’s first take a look at the rise in long-term rates on the sovereign segment.
First of all, rest assured that this rise has nothing in common with that seen in certain European countries in 2011-2012 following the “eurozone crisis”. In contrast to what we saw at that time, investors are no longer worried about the solvency of states, even though public debt has surged during the Covid-19 crisis. In the eurozone in particular, the ECB has drawn lessons from the previous decade, and will actively continue to absorb the debt of European countries as part of its “pandemic emergency purchase programme” (PEPP).
The rise in sovereign rates is therefore mainly explained by the return of inflation. In the eurozone, the price index surprised on the upside in January, posting a rise of 0.9% compared with January 2020. In the US, inflation is nearing 1.5% after having fallen to 0.1% last June. The “reflation” of the economy is set to continue this year, magnified by a strong base effect after 2020 was marked by falling oil prices. Other factors will be the rise in prices in 2021 driven by the economic recovery and the need, for companies, to increase their margins as much as possible to pay off their debt.
In Europe, 10-year rates have thus picked up by around 35 basis points since the beginning of the year. The German Bund, which was trading at -0.60% at the end of December, returned to -0.25% in the last week of February. The French OAT of the same maturity climbed by -0.35% to 0%, while 10-year Spanish rates rose from 0% to +0.40% in the same period. Italy remains a case apart, with the arrival of Mario Draghi at the helm of government having a calming effect on long-term yields. In the US, the movement has been even more pronounced: 10-year Treasuries have gained 55 basis points since the beginning of the year, rising from +0.90% to +1.45%. The upturn in inflation is complemented by the expectation of strong issuance volumes related to the Biden administration’s proposed USD 1.9 trillion stimulus plan.
The upside pressure on long-term rates is therefore expected to continue this year. Short-term rates remain in the grip of central banks, and do not seem capable of rising at this stage. The ECB is unlikely to raise its key rates before 2023 at the earliest, the Fed is ready to keep its rates at their floor level, even in the event of inflation returning to above 2%, and the Bank of England (BoE) is considering applying negative base rates.
High yield: risk premiums return to their pre-crisis levels
More generally, the economic recovery expected this year should lead to a fall in leverage after its sharp rise in 2020. This prospect is now supported by an improvement in the credit ratings allocated to companies by specialist agencies such as Moody’s. The wave of downgrades now seems clearly behind us.
This favourable environment explains the détente currently seen on “risky” corporate debt. With a fall of 20 basis points in a single week at the beginning of February, risk premiums in the high yield bond segment have returned to their pre-pandemic levels. This movement is beneficial for holders of these securities: remember that when market rates fall, the value of securities held in portfolios rises.
In short, unlike sovereign debt, high yield bonds confirm their interesting profile in connection with the hoped-for economic recovery in 2021. The potential for these spreads to narrow is undoubtedly now limited, but we believe the yields offered by this market segment are still attractive.
Finally, the default rate on the high yield segment is expected to fall over the next few months, to return to its historic average of around 2% to 2.5% at the end of the year, after reaching an expected peak of 5.4% in March, according to Moody’s. It is interesting to note that this last figure, which recalls the risk inherent in this asset class, in the end remained much lower than anticipated at the beginning of the Covid-19 crisis.
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Risks specific to the high yield segment: risk of capital loss, credit risk, interest rate risk, risk associated with derivatives, counterparty risk, risk associated with emerging countries, risk associated with asset securitisation, equity risk. In connection with fund management on the high yield segment, there is also a risk associated with discretionary management.
Article prepared on 25 February 2020. The information provided should not be considered as investment advice, and is for information purposes only. The data in this document are used in good faith, but no guarantee can be given as to their accuracy. All data contained in this document come from Lazard, unless stated otherwise. Past performance is not a reliable indicator of future performance.
For more information, please contact Eléonore Bunel, Head of Fixed income management at Lazard Frères Gestion.