Bond market review of quarter one 2011
As we said goodbye to 2010 and welcomed in the New Year,
investors in bonds would have found it difficult to ignore the
doomsayers who were collectively forecasting a rout in the asset
class. The quickening global economic recovery and a resultant rise
in inflation and interest rates were cited as the chief catalysts
to desert fixed interest securities and move down the corporate
capital structure to where the real money could be made. We are
pleased to report, as expected, the death of bonds was greatly
exaggerated and attractive risk-adjusted returns were available to
those prepared to hunt for value. The tail risk events created by
the ongoing funding issues affecting peripheral Europe, the social
and political upheavals across the Middle East and North Africa,
and the earthquake tragedy in Japan all served as timely reminders
bonds have desirable attributes during times of stress. Reduced
volatility, visible cash flows and the promise to get repaid are
all factors which can help bond investors sleep a little easier
than equity investors when the outlook is uncertain.
We should stress the paragraph above should not be
interpreted as a message that capturing these returns has been
straightforward. Western government bonds have delivered negative
returns during the quarter. US Treasuries lost 0.07%, gilts lost
0.83% and German and French issued debt fell 2.27% and 1.93%
respectively - all figures in local currency terms. US government
paper did much better than forecast with QE2 keeping yields down.
Other supportive factors were escalating geopolitical risks, the
lack of an alternative to the US dollar as a reserve currency and a
rise in private sector savings in the US. The benign inflationary
outlook has also supported prices, albeit the medium term outlook
is less clear.
The continuation of very accommodative monetary policies
across the Western world has underpinned the price of risk assets
generally, and the high yield subcategory of the bond universe has
been a key beneficiary of this. European high yield has returned
2.83% over the first three months of the year, as issuance has not
been able to keep up with demand. US high yield has done even
better, rising just over 4.00% as investors have become
increasingly focused on favourable credit metrics. Emerging market
debt has also made progress over the quarter with a 2.56%
uptick.
Looking ahead, what do we need to be thinking
about?
A consistently high oil price will begin to impact retail
sales, consumer confidence and spending patterns. The price of a
gallon of petrol in the US has risen to approximately $3.50.
Historically, $4.00 has been a psychological trigger that drives a
change in US consumer behaviour. If this was to occur, investors
will have to reassess their outlook on global growth and risk
assets will undoubtedly reprice. This will be the result of a shift
in interest rates and inflation expectations - the two most
important influences on bond markets.
Inflation in Western bond markets is not a near-term
concern, but further out, the picture is less clear. Excess
liquidity and rising economic activity will fuel inflation
pressures, and policy makers in the major central banks face an
extremely difficult set of challenges as they seek to manage price
stability and growth. The timing of exit strategies will be all
important as a double-dip recession cannot be discounted. This is
not our central view - we believe the global recovery is gaining
momentum - but it is a risk we are mindful of, particularly in the
UK.
Economic newsflow around the topic of interest rates will
shape the opinion of market participants, although it is extremely
difficult to forecast when rises will be timed. We anticipate the
rhetoric from policy makers around the subject of raising interest
rates will build later in the year and we want to be ahead of the
curve.
Finally, we cannot conclude without making reference to
European sovereign funding issues. Portugal has joined Greece and
Ireland in seeking a bail out from the European Financial Stability
Fund. In the days leading up to this, Portuguese banks were
downgraded, followed by the sovereign itself. The fact European
bond markets were relatively untroubled by these events is in sharp
contrast to May 2010 when Greece was suffering a similar fate.
There appears to be an acceptance a solution will ultimately be
found to the funding issue, but our task, as asset managers, is to
make sure market acceptance is not market complacency. Confidence
in the entire European banking sector relies on a satisfactory
resolution and we believe this will, at some stage, be achieved.
Before this is reached, however, we are anticipating periods of
heightened tensions and nervous markets.
To summarise, over the next reporting period we see strong
fundamentals underpinning corporate credit and low default rates
continuing to support high yield. We anticipate developed world
economies to strengthen, but remain weak in historical terms, and
we foresee the possibility of periodic risk aversion following
adverse geopolitical and economic newsflow. We expect hawkish
voices in Western central banks to get louder, but we also believe
the hunt for yield will remain strong as interest rates will take
some time yet to normalise. To us, this environment continues to
present opportunities for bond investors.
Key:
Investment grade - Investment grade is a bond that is
assigned a rating in the top four categories by commercial credit
rating companies. S&P classifies investment grade bonds as BBB
or higher, and Moody's classifies investment grade bonds as BAA or
higher. The ratings are based on a number of criteria, including
the likelihood that the bond issuer will be able to make interest
payments and repay the principal in full and on time. In general,
investment grade bonds are considered to be relatively lower risk,
and consequently deliver a lower return.
High yield - High yield is a term used to describe bonds
issued with a lower credit rating than investment grade and, due to
the higher risk of default or other credit adverse event, pay a
higher coupon to attract investors.
Duration - Duration is the weighted average term to
maturity of a bond's cash flows and, therefore, is a valuable tool
in assessing bond price sensitivity to interest rate moves. As a
general rule, the greater the value of duration, the more price
volatility results from changes in interest rates. Modified
Duration is a formula used to determine the effect that a 1% change
in interest rates will have on the price of a bond or bond
portfolio. For example, a bond with a five year modified duration
will decrease in value by 5% if interest rates rise 1% and increase
in value by 5% if interest rates fall 1%.
All data herein is sourced from local exchanges via
Reuters, Bloomberg and other vendors. The information herein has
been obtained from public sources believed to be reliable.
Fairbairn Private Bank makes no representation as to the accuracy
or completeness of such information.