The main focus of our thinking is the timing of the next recession. If a recession causes defaults to increase, then owning too many high-yield bonds for too long could be dangerous. At the moment, not many loud alarm bells warning of imminent recession in the US are ringing. But one is: the slope of the yield curve.
When the gap between yields on long-dated (which are usually higher) and short-bonds (usually lower) shrinks to the point that it inverts, we have historically seen a recession nine months or so later. And if we look at 10-year yields relative to two-year yields, we’re not far off that happening again. (Indeed the 10 year-3-month yield part of the curve inverted in March).
The yield curve flattens – inversion next?
US Treasury 10-year yield – 2-year yield (basis points)
Source: Bloomberg as at 31 March 2019
Further, any trade disputes could easily tip the developed world into a recession. At present, President Trump looks to be heading towards making some form of deal with China. The danger is he will regard this as a victory and then turn his fire on Europe. We will see.
More worrying is anaemic growth in Europe. Last year was hardly exciting – but prospects for future growth look paltry at best. Italy is a particular worry. The government continues to spend profusely, even though overall debt levels are dangerously high. Germany, meanwhile, continues to run a budget surplus. This may seem commendable but doesn’t help its neighbours. The German economy is particularly sensitive to global trade so a trade war would severely affect it. Moreover, the decline in demand for cars and new emissions legislation represent real challenges. France is struggling with high taxation and an unsettled electorate. The gilets jaunes protests have been a symptom of this malaise. Growth remains moribund, partly due to high taxes.
Europe’s worrying levels of debt
European government debt to GDP (%)
Source: Bloomberg as at 31 March 2019
A rough rule of thumb is that when countries’ borrowing relative to their GDP exceeds 100%, it can be the tipping point where they start to struggle to finance themselves. There are exceptions, of course. Japan has a deficit of around 250 per cent of annual GDP. But it has the advantage of being able to print its own currency, a high savings ratio and a balance of payments surplus. Of these positives, Italy only has a high savings ratio. In the short term, it must rely on the European Central Bank to provide QE. We worry that Italy’s debts could again start to worry investors. If that were to occur, US Treasuries would probably perform well.
A recession is perhaps not imminent – in fact central banks have probably extended the economic cycle. But that “high-yield” bonds in Europe are being issued with coupons of less than 3 per cent seems like an oxymoron. Remember that a high-yield bond is defined as one that “may struggle to survive throughout the economic cycle”. So, for us, it seems prudent to reduce our weightings here as we approach the next recession. And with UK political risk so high this almost by default means increasing our weightings to US Treasuries.
The Artemis Strategic Bond Fund therefore retains a higher proportion of government bonds than it has in the past. While not imminent, a recession feels more likely than it once did. Europe has excessive borrowing, especially in certain countries. And when – or if – fear of sovereign defaults in the eurozone increases, investors are likely to hide in US sovereign bonds. We want to be prepared.
To find out more about the Artemis Strategic Bond Fund and view its latest performance and composition, please visit the fund factsheet page.
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Investment risks and important information
To ensure you understand whether this fund is suitable for you, please read the Key Investor Information Document and Costs and Charges Information document, which are available, along with the fund’s Prospectus, from www.artemisfunds.com. The value of any investment, and any income from it, can rise and fall with movements in stockmarkets, currencies and interest rates. These can move irrationally and can be affected unpredictably by diverse factors, including political and economic events. This could mean that you won’t get back the amount you originally invested.
The fund’s past performance should not be considered a guide to future returns. The fund may use derivatives (financial instruments whose value is linked to the expected price movements of an underlying asset) for investment purposes, including taking long and short positions, and may use borrowing from time to time. It may also invest in derivatives to protect the value of the fund, reduce costs and/or generate additional income. Investing in derivatives also carries risks, however. In the case of a ‘short’ position, for example, where the fund aims to profit from falling prices, if the price of the underlying asset rises in value, the fund will lose money. The fund may invest in fixed-interest securities. These are issued by governments, companies and other entities and pay a fixed level of income or interest. These payments (including repayment of capital) are subject to credit risks. Meanwhile, the market value of these assets will be particularly influenced by movements in interest rates and by changes in interest-rate expectations. The fund may invest in higher yielding bonds, which may increase the risk to your capital. Investing in these types of assets (which are also known as sub-investment grade bonds) can produce a higher yield but also brings an increased risk of default, which would affect the capital value of your investment. The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities. The fund may invest a portion of its assets in a currency other than the fund’s accounting currency. The value of these assets, and the income from them, may decrease if the currency falls in relation to the accounting currency, in which the fund is valued and priced. The distribution yield is an estimate of the income that you might expect to receive from your investment over the forthcoming year as a percentage of the fund’s mid-market unit/share price. It does not include any preliminary charge. Investors may be subject to tax on any distributions they receive. The fund is an authorised unit trust scheme. For further information, visit www.artemisfunds.com/unittrusts.
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Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.
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