Bond market review quarter 4 2010
Our attention has previously focused on the size and scope of a
potential second tranche of market intervention by the Fed in the
form of quantitative easing - or QE2, as it had become known. This
duly arrived in November prompted by a period of soft economic data
in the US through the late summer. As we know, this policy is in
place to keep market interest rates low, inflate asset prices, and
boost corporate investment and consumer spending. Importantly, for
bond investors, we should remember the Fed has a mandate to
maintain high levels of employment and, with one eye on this
obligation, will retain very accommodative monetary conditions
until it sees a sustainable fall in the unemployment rate.
Ironically, the US$600bn asset purchase programme - that is QE2 -
got underway just as economic newsflow improved and sentiment
towards US growth prospects turned more positive as the year came
to an end. This outlook, plus an element of 'buy on rumour, sell on
fact', prompted an initial sharp rise in US Treasury yields, which
later moderated during December. This moderation is important as it
demonstrates market participants remain cautious of an economy
which still faces a prolonged period of deleveraging for sovereign,
personal and bank balance sheets.
This rise in US Treasury yields was accompanied by a rise in
core European government bond yields also stoked by an improving
growth outlook, but principally by a continuation of the sovereign
credit crisis as commentators began to speculate the financial cost
Germany may face to keep the euro project alive. Gilt yields rose
too, however, investors enjoyed solid returns from these securities
during 2010 of 5.81%, 6.30% and 7.63% respectively, in local
currency terms. Fixed income investing, generally, was very
rewarding on a risk-adjusted basis across the credit spectrum, with
the USD high yield sector returning 14.29% and the same sector in
Europe returning 12.03% over the year. The sterling non-financial
investment grade* credit sector delivered 9.17%. These returns,
which followed robust returns during 2009, have prompted
speculation 'bond' markets are in a 'bubble' and investors should
be wary of the asset class. While we would agree that government
bond issues of some developed markets look very expensive and offer
little cushion against either interest rate rises or inflation, it
is our view investors should stay mindful of the breadth of the
fixed income sub-sectors and note value can still be found.
Moreover, with the opportunity to invest in high yield, or
Libor-linked, or short (or negative) duration*, or inflation-linked
instruments investors can manage the risks presented by rising
interest rate or inflation sentiment.
Capital flows into fixed income assets have remained very
strong, albeit reports indicate these flows have tempered during
the final quarter of the year. This is to be expected at this stage
of the economic cycle as investors rotate into higher risk assets
given the improving landscape. Notwithstanding this, over the
medium to long term we believe changing demographics and ageing
populations in developed countries will increase the demand for
yield assets and bonds will be an essential component of retirement
portfolios. Regulatory changes will also support bonds as there is
a requirement for banks to hold more government debt for liquidity
purposes. If we add to this the pro-cyclical sector of emerging
market (EM) debt, it seems apparent to us fixed income should
remain a core asset allocation for investors.
Looking ahead
Our expectation continues to be low growth and relatively low
inflation in the developed economies of the world and this will
keep interest rates low. We believe government bond yields will
rise but economic uncertainties - particularly in Europe - will
spark periods of risk aversion and this means the fall in prices
will take time. This outlook contrasts with the developing world
where we see strong growth and sound public, corporate and
household balance sheets increasingly supporting consumption.
Upward pressure on interest rates and inflation can be expected
given the vibrancy of these economies.
Investors in traditional fixed income assets receive a series of
cash flows, being coupon payments and the return of the principal
invested, on maturity. The value of these cash flows is influenced
by inflation during the term of the bond and changes in interest
rates affect the price. These two factors are, therefore, crucial
and managing these risks is key to us fulfilling our mandate of
delivering a cash plus return while preserving our investors'
capital. If we believe interest rate sentiment is hawkish - ie,
rates will rise - we can invest in bonds which do not have a fixed
coupon, but a variable one which rises on a periodic basis in line
with money market - Libor - rates. This protects the price of the
bond, or, put another away, shelters the capital invested in a
rising interest rate environment. Alternatively, if we believe
inflation is a threat to the value, or future purchasing power, of
our investors' capital we can address this by investing in
inflation-protected bonds issued by public (government) and private
(corporate) entities. If we add into this mix the ability to buy
high coupon (high yield) debt, we can provide further shelter to
investors from rising interest rates and inflation as the value of
the coupon payment is reduced much less, proportionately, than
lower coupon (investment grade*) debt.
By being prepared and maintaining our disciplines around
investment process and valuation, we continue to believe selective
sectors within the fixed income arena will deliver attractive
risk-adjusted returns to investors in 2011. We expect periods of
risk aversion and given their position in the corporate capital
structure our preferred bond allocations will provide shelter
during these storms.
* Key
Investment Grade - Investment grade is a general term used to
describe how a bond is classified by various indexes and ratings
companies. No one company issues an 'investment grade' stamp of
approval. Instead, it is a term often used by investment houses or
corporations to inform a potential investor of the low risk level
of a bond.
Duration - The duration of a bond refers to its weighted average
life. Bond duration is a measurement of how long in years it takes
for the price of a bond to be repaid by its internal cash
flows.
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.