How can investors dull the bite of a cyclical bond bear market?

It might be time to consider balancing traditional government bond exposure with other income-generating vehicles

How can investors dull the bite of a cyclical bond bear market?

While early indications of a cyclical bond bear market suggest nothing much worse than low single-digit losses for the overall bond index, investors who want to avoid losing ground with their investments may still consider several options.

In a recent commentary, David Stonehouse, senior vice-president and head of North American and Specialty Investments, AGF Investments, suggested that investors get ahead of a cyclical bond bear market by counterweighting their government bond exposures with other income-generating vehicles.

One possible option, Stonehouse said, is high-yield credit, which has historically benefited when the number of companies declaring bankruptcy and defaulting on debt rise – a scenario he said is likely to play out as the U.S. and global economy plods toward a full recovery.

“Severe recessions tend to lead to corporate deleveraging, which helps purge credit markets of overleveraged companies and create new opportunities for investors,” he said. A downside overreaction in the markets, he added, could create opportunities for investors who can recognize which credits have been de-rated at a substantial discount, and have the ability to avoid default and trade back up to par values.

Convertible bonds are another vehicle to consider as they’ve demonstrated strong hedging abilities over the past six cyclical bond bear markets. Aside from consistently and substantially outperforming traditional bonds, based on data from Bloomberg as of October 31, Stonehouse said their low correlation to other fixed-income types makes them a strong diversifier.

“[T]heir potential to convert into equity provides upside potential in a strong equity market, while their standing as a bond provides downside protection in a weak equity market,” he said, adding that convertibles have historically generated positive returns when regular bonds delivered negative returns.

Finally, he pointed to the potential of emerging market bonds, whose prospects he predicted are much better today than the last cyclical bear in early 2016 to late 2018. The decline of more than 5% in the J.P. Morgan Emerging Markets Bond Index during that period, he pointed out, happened against a backdrop of relative U.S. dollar strength and rate-hiking activity from the U.S. Federal Reserve.

“[A] more accurate precedent today might be the Global Financial Crisis and the cyclical bear that followed it, when EM bonds performed admirably,” he said, noting that the four months following the EMBI’s trough in October 2008 saw it gain nearly 12%. From there, it rose by another 35% to the end of the cyclical bear in early 2010.

Since troughing in March this year, Stonehouse said EM bonds have advanced nearly 18%, and have the potential to keep going as near-zero rates maintained by the Fed relieves pressure on U.S. dollar-denominated EM debt. At the same time, he said elevated U.S. debt should curb prospects of further appreciation in the greenback. Rebounding commodity prices and a firming-up of the global economic recovery, he added, should benefit emerging-market economies and their bonds, though it won’t be evenly beneficial across all developing markets.

“Our general approach to emerging market bonds is to be selective; however, the next cyclical bond bear market could accompany a rising tide for the segment as a whole,” he said.


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