The coming months look likely to be more profitable for bond investors as interest rates in Britain and Europe show signs of falling and investment grade corporate credit offers good opportunities.
Investors in global bonds have had a rocky ride over the past few months. Government bonds generally rallied in the first quarter, in expectation of lower interest rates and as investors sought a safe haven from the turmoil in credit markets.
The resurgence of inflation concerns led to a major reversal as the market moved to price in rate hikes rather than rate cuts by the leading central banks. From a low of 3.7% in March, the yield on two-year British government bonds rose to over 5.5% in June. Returns on British bonds overall were down some 3.6% in the second quarter. There was a similar picture in America and Europe.
The only respite for fixed income investors was that the corporate bond market saw some recovery, resulting from better sentiment following the rescue of the investment bank Bear Stearns by America’s Federal Reserve. This led investors to believe that central banks would not allow a leading financial institution to fail. In addition, capital raising exercises by a number of banks – rights issues, investment from sovereign wealth funds – sent a positive signal to debt investors that banks were rebuilding their balance sheets. However, returns from credit over the quarter were still negative, just not as bad as those from government bonds. More recently, sentiment has swung around again. Government bonds have rallied as investors decided that central banks, wanting to counter weakening growth, were more likely to cut interest rates. In addition, various factors pointed to some moderation in inflation in the coming months. The turnaround in interest rate expectations was particularly marked in Britain, where the two-year yield rallied all the way back to 4.5%. Meanwhile, the credit market has found it hard to hold on to its short-lived optimism. Banks have reported further writedowns and concerns are growing about the impact of an economic slowdown on corporate profits.
So what do the coming months hold for fixed income markets? With interest rates in America already low, the main scope for easier monetary policy appears to be in Britain and Europe. While European Central Bank rhetoric may still focus on the inflation threat, the deteriorating growth picture indicates that rates there will have to come down at some point.
In Britain the situation is more clear cut: comments from the Bank of England indicate that it now sees averting recession as its more pressing focus. Moreover, with commodity prices falling and the risks of inflation feeding through into wage growth relatively low, given rising unemployment, some improvement in the inflation data can be expected in the coming months. We therefore expect the remainder of 2008 to remain supportive. After all, slow economic growth, falling inflation and expectations of lower interest rates are normally conducive to good bond market performance.
And what of the credit markets? After the pain investors have suffered, should they remain wary or are there opportunities? Spreads on high-quality investment grade corporate bonds are at levels not seen in the past 10 years. Last summer investors were paid a premium of about 0.5% over government bonds to invest in corporates – now you get close to 2%.
This sell-off was not driven by a reassessment of companies’ fundamentals but by a repricing of risk and the drying up of market liquidity. With the forced selling caused by investors’ need to deleverage apparently behind us, it is appropriate to focus on value once more. Spreads on corporates represent an excellent opportunity on a medium-term view.
However, stock selection is hugely important, particularly in an economic environment where companies could suffer. Having been the worst-performing area, financials have a brighter future now that they are working to repair their balance sheets. Furthermore, they are likely to be managed in a more cautious manner and to benefit bond holders at the expense of the equity investor.
Other sectors that look interesting are the utilities, which can pass on higher energy costs to the consumer, thus ensuring their own profitability, and areas such as healthcare, similarly less vulnerable in a slowdown. Conversely, retailers and consumer goods producers face a gloomier outlook.
We are somewhat more cautious on the outlook for the high-yield bond market. Default rates are picking up in America and Europe is likely to follow suit. Owning high yield into a default cycle is not a comfortable place to be, particularly when the asset class looks relatively expensive compared with “safer” parts of the market, such as investment grade.
When selecting a bond fund – particularly one that can invest in corporates – investors should favour those that make use of strategies that can capture both the positive and negative trends and stories within the market. Credit default swaps allow a manager to put in place a negative view on a company, which can be done outright or as part of a relative value strategy. An example of this would be to prefer British Telecom over Vodafone.
This type of low-risk strategy is not affected by the direction of the overall market or even the telecoms sector; it is just a play on one company having a relatively better performance than the other. Moreover, in a challenging environment, being able to express outright negative views on certain names can also increase opportunities.
Overall, the coming months look set to be more profitable for bond investors. Expectations of lower interest rates should be positive for the general direction of the market. Meanwhile, the excellent investment opportunity available in the investment grade credit market is starting to encourage renewed investment.
Given still fragile investor sentiment, the credit market may see some periods of volatility, but for those prepared to invest for the medium term – the next one or two years – the rewards are likely to be good. Crucial to success in the corporate bond world will be stock selection, and the ability to profit from both the winners and the losers.