Bond market review of quarter two 2010
Right around the world, the investment worry
uppermost in most people’s minds during the second quarter of 2010
has been a sovereign default within the eurozone debt markets. The
problems encountered by Greece and other sovereign issuers have
been well documented, as has the €750bn rescue package which was –
eventually – put in place by the EU, with the help of the IMF. For
many, however, there is still more to come from this story and the
continuing threat this brings is likely to shape the mindset of
investors for a number of quarters to come. This is particularly
relevant to bond investors who have seen the asset class, and a
number of the sub-sectors within it, endure a volatile and
sometimes unpredictable few months.
Returning to the issues in Europe, bond
markets were, clearly, reassured by the intervention of the
authorities in May and they have been equally reassured by the
austerity pledges and fiscal consolidation plans announced by
member states. This has, however, caused market participants to
downgrade their economic forecasts, and the risk fiscal tightening
might hurt activity, at a time when the recovery is very fragile,
has lead to a re-pricing of all asset classes. In government bond
markets, investors recognised sovereign debt sustainability
remained far from assured and capital flowed to the traditional
safe havens of US Treasuries and, to a lesser extent, German bunds.
UK gilts were also beneficiaries of this funds flow and delivered a
4.75% return for the 3 months ending June 2010. The early weeks of
the new coalition government have been well received by the gilt
market and the returns delivered have come as a surprise to some
given the fiscal and budgetary challenges the country
faces.
Corporate spreads across investment-grade and
high-yield debt widened during the second half of the quarter as
concerns over a sovereign default posed downside risk to credit
markets. Fear clearly overshadowed the improved creditworthiness of
the corporate sector as strong earnings and profits had continued
to boost balance sheets. The potential contamination risk to debt
markets was highlighted by the intensifying crisis in Europe
causing US investment-grade spreads to widen by 45 basis points
during the quarter and high-yield spreads to widen by 130 basis
points. Liquidity in secondary markets demonstrably thinned as risk
aversion intensified and, while this has improved, we have not yet
returned to the conditions enjoyed earlier in the year. Consistent
with the negative sentiment that swept through markets, emerging
market sovereign debt yields also widened versus US Treasuries.
Throughout the quarter, one trend that did
remain was the desire of asset allocators to commit capital to bond
funds. Managers have reported healthy flows and the natural
inference is that the asset class has firmly returned as a core
holding for many.