The inaugural SPDR Bond Compass from State Street Global Investors shows that despite recent market volatility, investors remain cautiously optimistic about medium-term growth.
The Bond Compass is a new initiative from the research and trading division of State Street and presents a snapshot of global fixed income flows and holdings indicators. The report is to be issued quarterly and State Street hopes it will provide a unique insight into how investors are positioning their portfolios based on State Street Global Markets' global fixed income flows and holdings indicators.
Speaking about the results for the third quarter, Michael Metcalfe, global head of macro strategy for State Street Global Markets, said that bond flows indicate that investors view the inflation outlook as "broadly benign" and not currently unduly troubling. This trend was confirmed by State Street's online metrics through early October.
"What we are seeing is a re-assessment of risk and a review of holdings across the curve, but not wholesale protection purchasing," he said. "If you add to that some modest buying of credit, the flows seem to indicate that long term investors are not panicking just yet."
Looking into the detail from the report, it suggests that in effect a "tug of war" took place in the previous three months between an evident flight to safety and improving fundamentals. The report concludes the "fundamental won", thus creating a challenging environment for fixed income returns.
Still, the Bond Compass does suggest there bright spots for fixed income investors:
Corporate bond demand:
Primarily in the US, demand in corporate bonds picked up in the middle of the quarter. "For all the talk of the US being late-cycle, demand for credit remains as healthy as the economy still looks," the report's authors wrote.
Weakening demand for TIPS:
The report notes that demand for Treasury inflation-protected Securities or TIPS was weaker than expected which the report surmises that as robust as the US economic data has been of late, investors are not overly concerned about the economy overheating just yet.
Sovereign market inflows:
Lastly, the Bond Compass suggests that inflows into sovereign markets stabilised over the course of the quarter. This came after one of the weakest quarters in five years in the second quarter.
The authors noted that investor flows in Europe were more surprising that in the US with a only a modest weakness in Italian bonds (BTP) suggesting that investors were already underweight ahead of the looming budget battle between the EU and the populist Italian coalition.
Demand for gilts, on the other hand, was robust which as the report suggest is due to investors seeing them as a potential hedge against the consequences of a no-deal Brexit.
The Bond Compass points towards two further notable bond flows away; first, the demand for credit, even high0-yield credit, has improved in spite of concerns that the market is entering the "late period in the US cycle" - i.e. the 10-year old bull market is coming to an end.
Second, that demand for inflation protection has also fallen, suggesting that fears of the US economy overheating are overdone.
"While 'risk off' trades have not been running strong, what remains to be seen is whether investor's selective 'risk-on' appetite remains intact into the latter half of the last quarter when allocations typically become more dynamic and market volatility more entrenched," commented Antoine Lesné, head of EMEA strategy and research for SPDR ETFs.
In terms of index performance and yields, the Bond Compass shows that the third quarter witnessed a rise in US Treasury yields, sending rate-sensitive sectors lower and constraining the total return of the Bloomberg Barclays US Aggregate Bond Index given its sizeable weighting in US Treasuries - circa 37%.
The Bond Compass shows that similar price patterns occurred overseas, with Euro and UK government bonds falling as central bank policy makers indicated potentially more restrictive policies in the future.
Meanwhile, credit-sensitive sectors posted positive returns in the third quarter with US high-yield outperforming investment grade, continuing a year-long trend. Fixed-rate high-yield also outperformed global convertible bonds year to date as equity markets fell in the last days of the quarter and spreads tightened close to 50 basis points through the summer.
Lastly, when it comes to merging market volatility, the Bond Compass shows that yields appeared to have stabilised. The report suggests EM may represent an attractive opportunistic yield play, albeit the macro risks remain elevated given the backdrop of trade war fears upending growth dynamics, a hawkish Fed, and higher currency volatility.