This Manager’s Bullish on Bonds – But Suggests Waiting a Bit

It’s been a painful time for fixed income investors whose funds have only gone sideways for the past five years. Yet veteran fixed income manager Kaspar Hense argues that investors will be rewarded finally, provided they are a little more patient and wait until later next year.

The main reason for his optimism is that global sovereign bonds, which invest in securities issued by governments around the world, are now cheap. In the upside-down world of bonds, interest rates and prices move in opposite directions, with the result that bonds that pay high interest rates, such as now, are inexpensive.

“We think the market is very cheap, both backward-looking and forward-looking. But it will become even cheaper in the near term,” says Hense, co-manager of the $1.8 billion gold-medalist 3-star BlueBay Global Sovereign Bond Fund (Canada) F (also available in Series D). Hense is a senior portfolio manager within the BlueBay investment grade team of London, England-based RBC Global Asset Management (UK) Limited.

“The next three to six months are highly uncertain with regard to the Federal Reserve’s policy and inflation will stall here at roughly 4% in the U.S., for example. That makes monetary policy quite difficult. Also, there are challenges with fiscal policy in the U.S., which has been very loose. Long-term, bonds are attractive, but we are quite concerned for the next three-to-six months.” Hense is an 18-year industry veteran who is part of a 17-person team that oversees an aggregate US$20 billion in fixed-income assets and is headed by Mark Dowding, chief investment officer at BlueBay.

Bonds May Be Worse Before Better

Long-term prospects are attractive. Indeed, Hense anticipates that by later next year investment returns might be in the high single digits—if investors are prepared to wait that long.

Year-to-date (Oct. 30) BlueBay Global Sovereign Bond (Canada) F has returned -1.09%, versus -0.68% for the Global Fixed Income category. Over the past five years the fund has fared better, however, and been a second-quartile performer. It returned an annualized -0.31%, versus -0.47% for the category.

Tide on Bonds Will Turn Even with Trump Uncertainty

Hense notes that it’s highly unusual that U.S. treasuries have been negative performers for the past three years in a row. But the tide will turn, he argues, in the second half of 2024. “Bond vigilantes are keeping the market on its toes. Fiscal policy in the U.S. is far too loose. So there is some long-term unsustainability and it won’t go away in an election year. If Trump will win [the U.S. presidential election] there are some question marks about that,” says Hense, adding that regardless of the outcome interest rates will eventually decline as GDP growth slows.

The third quarter in the U.S. may see GDP growth of around 5%, although some market estimates put third-quarter growth at around 4.3%. “Recession fears have been pushed into the second quarter of next year when monetary policy will get a better grip [on the economy]. But ultimately, it’s expected that monetary policy will gain the upper hand in the battle with fiscal policy. Then we will see a more pronounced slow-down.”

Hense believes it is highly likely that the Federal Reserve has done raising rates, although there is the potential to raise them some more. “But quantitative tightening and the huge amount of issuance [of treasury bonds] will put enough pressure on markets to slow economic growth down going forward,” says Hense, who has earned a double Master’s degree in financial management from Christian Albrechts University in Kiel, Germany and the University of San Diego. “We have seen financial conditions tighten in the last two months, although the Fed hasn’t really done anything. Bond markets need weak economic data to turn flows away from equity markets and into bond markets. We expect this to happen, but it could take some months.”

Waiting for Weakness Before Buying U.S. Bonds

While there is a battle of sorts between U.S. fiscal policy and monetary policy, “We need to be very careful and not be too early and go long into fixed income. We need to see how the data develops,” says Hense. “What we know is that suddenly we may see value in fixed income. It will be there when we see much weaker growth. But right now, with U.S. fiscal policy being dominant, the U.S. is structurally not yet the place to be long bonds. If we see substantial weakness, especially in the labour market, we will engage structurally in the U.S. market.”

From a strategic viewpoint, about 36.6% of the invested portfolio is in international bonds (as of Sept. 30), 33.6% in the U.S., 25.7% in emerging markets (EM), and 4.2% in Canada. There is also 21.1% cash, which indicates the fund managers’ defensive posture. The duration for the fund is 6 years, versus 6.1 years for the benchmark FTSE World Government Bond Index C$. The fund, which is primarily invested in investment grade securities, has a running yield of 3.1%, before fees. The benchmark, by contrast, has a running yield of 2.5%.

Emerging Markets Are Already Cutting Rates

While the team is keeping U.S. exposure at very low levels, and also staying short on Japan, they see some pockets of value in the EM space. “Inflation has come down to their targets and they are looking at cutting interest rates from very high levels. We had double-digit levels in investment-grade countries such as Mexico and Hungary. In Hungary, for example, they have started the cutting cycle. In others, they are somewhat more orthodox and want to be a little more prudent and want to wait for the Fed to give them signals so there is no volatility in their own markets. As soon as we see weakness in the U.S., then some of the emerging markets will look very attractive.” He adds that management teams such as his must be wary of the higher interest rate environment because the risk of default has also risen accordingly for some countries.

Running a portfolio of about 101 holdings, Hense points to examples of emerging market securities issued by Greece, whose bonds have recently been upgraded to investment-grade by Standard & Poor’s. “They have been a very positive growth story and have reduced the ratio of debt to GDP in the last decade from 270% to 160% and expect to go to 140% in the next two to three years. Most of their debt is with the European Union. But their tradeable debt is just US$90 billion in size, which is just a small portion of GDP. We expect that debt to shrink.” Moreover, as passive investment funds develop an appetite for Greece’s bonds, Hense expects that trend will push their prices gradually higher.       

The Greek government bond, which matures in 2033, is yielding about 4.5%, or 160 basis points over similarly dated German government bonds. Because of a currency hedge in place, the yield is close to 5.5%.

Another representative holding is from the government of Romania. While it is a small market, Hense believes that in time, Romania will join the Eurozone. “They had a rather prudent fiscal policy where debt to GDP went from roughly 40% to above 50% in the pandemic. Most other countries have grown at much higher rates. Currently, they are enjoying very high nominal economic growth. That means, they are deflating their debt and we expect the debt to GDP growth ratio to fall to around 40% in the next two years,” says Hense, adding that the debt to GDP ratio may fall even further. The 10-year Romanian bond is yielding about 7% in C$ terms.

Well-Rounded Global Bond Fund Strategy

In terms of methodology, the BlueBay team focuses on policy and politics and consequently tries to be close to policymakers and central banks. “That’s our edge,” says Hense, proudly. Indeed, a team member recently visited Romania’s capital, met with the finance minister and exchanged views with debt managers to get a better understanding of Romania’s intentions.

“In general, we look at four input factors: fundamentals, technicals, valuations, and sustainability. But with the focus on policy and politics, we have integrated sustainability anyway. We are always looking at economic measures with a transition to a green economy and what impact these measures may have from a longer-term perspective,” he says, adding that Greece has made a significant shift to solar energy, which the team believes will have a positive impact on its economy, and by extension its bonds.”

Looking ahead, Hense maintains that in 2024 investors will want to own sovereign bonds. “It will be mostly driven in the second half of 2024. So there is still time to decide. Since returns will top yields, you will not only earn a 4% yield, but price appreciation on top of that,” says Hense.

Assuming that late next year the U.S. 10-year treasuries have fallen to 4%, from the current 5% level, an investor will earn another 3.5% in capital appreciation. “Your return next year should be around seven to 7.5%.”