Following the unexpected victory of Donald Trump in the US presidential election on 8 November, long-term interest rates have spiked. The 10-year US Treasury yield has hit an 11-month high of 2.3 percent, increasing around half a percentage point in a week, and interest rates have gone up in other countries including Germany.
There are various reasons for the uptick in the US. One view is that Donald Trump's economic policy will increase the US public debt, which will be inflationary. That is why we have seen an increase in long-term rates. Another view is that his policies will increase growth and that Donald Trump is likely to appoint two hawkish governors to the Federal Reserve, and this is putting upward pressure on long-term interest rates.
Tax cuts more important than budget deficits
When Donald Trump becomes president he will have a Republican lead congress which will make it easier for him to implement his economic policies. If, and that is not certain, he can get along with his fellow Republicans in congress.
History is on Donald Trump's side, however. Republicans often talk about being fiscally conservative when they are in opposition to Democratic presidents. Once in power they can often live with budget deficits and increasing debt burdens if tax reductions are large enough. There is nothing Republicans love more than cutting taxes. A good example of this was when Ronald Reagan was president between 1981 and 89; taxes were cut and budget deficits increased.
The effect has not been the same on corporate bonds, however. The global corporate bond fund SKAGEN Credit for instance has hardly moved since the US election. One of the reasons for this is that it has low duration and is therefore not very sensitive to interest rate changes. Since the beginning of the year SKAGEN Credit has had a return of 6.0 percent (in EUR).
Credit spreads neither low nor high
Average global credit spreads – the difference between the interest rates of government bonds and corporate bond yields – are around 2 percent at present. This is close to the average level over the last 16 years. The highest credit spreads were seen in the midst of the financial crisis in late 2008, when they reached 6.5 percent, whereas the lowest rates were seen in the spring of 2004 when they went below 1 percent.
As the default risk of the issuer increases, its spread widens. So a large spread in the midst of the financial crisis in 2008 meant that the market thought more companies would go bankrupt than was the assumption in the spring of 2004 when economic conditions were brighter.
"So far we have only seen a larger uptick in interest rates of government bonds. We have seen somewhat larger credit spreads in emerging markets, but this is natural. When economic uncertainty increases there is always a "flight to quality", that is money being withdrawn from emerging markets and reallocated to the US," says Tomas Nordbø Middelthon, portfolio manager of SKAGEN Credit.
Good opportunity for bond picking
Many investors do not differentiate between underlying yield and credit spreads. A sell-off triggered by a rise in US government bonds will also lead to a sell-off of corporate bonds. In many instances this seems to be for the wrong reasons since the company quality is the same.
"Picking the right bond that is sold for the wrong reason is a good strategy for the time being. In a climate in which long-term interest rates are on the rise, it is wise however to buy corporate bonds with a low duration and with moderate credit risk. In SKAGEN Credit we maintain a low duration (around 1) and we keep the credit risk rather low by having at least 50 percent of our holdings in investment grade corporate bonds," says Tomas Nordbø Middelthon.