Bond markets have been driven by two themes since the
beginning of April, one old and one new. The first is the ongoing saga of the
eurozone sovereign debt crisis. But the second theme has been the
materialisation of a new issue: a marked slowdown in economic activity around
the world. Employment growth in the US continued to lag what would be expected
in a normal recovery, and a slowdown in European activity has persisted, where
the impact of the “one size fits no-one” monetary policy continues to be felt.
Outside of Europe and the US, fears of a significant slowdown for China persist.
By the end of the second quarter 2012, central banks in the US and UK
were paving the way for the possibility of further money printing in the form of
quantitative easing, while the ECB made it clear that it would support the
region’s troubled banks. Bond yields fell sharply in the core markets. In the
US, longer-dated bonds outperformed, while in the UK and Germany,
intermediate-dated bonds found the most demand. By contrast, in peripheral
Europe, yields rose as doubts returned about growth, the financial health of
sovereigns and banks, and the viability of the austerity plans (Chart
1).
Insight Investment Management (Global) Limited (Insight) is of the
opinion that a continuation of sluggish growth in the world’s core economies is
expected. Insight is forecasting US growth to remain positive but below what
would be expected to be normal at this point in the recovery, while the eurozone
is likely to contract this year. Central banks are likely to continue to focus
on implementing measures to stimulate growth. US and UK policy makers have
reiterated their commitment to do whatever it takes to provide liquidity and
support credit growth, reflected in the extension of Operation Twist in the US
at the end of June and the UK’s extension of quantitative easing in early July.
The chances of the ECB embarking on broad-based quantitative easing are still
low as long as the situation in Greece does not spread, but the cut in interest
rates at the beginning of July was a positive sign.
Eurozone
makes slow progress
Pressure on eurozone sovereigns remains. In 2012 the
German bund market enjoyed a strong April and May, gave back much of those gains
during June, before rallying again in July. May 2012 had seen 10-year yields on
German, French, Norwegian and Dutch bonds falling to record lows as investors
fled to them as “safe havens”. Market speculation about Greece’s exit from the
EU reached fever pitch as the electorate initially failed to vote in a new
government, while the French voted in socialist leader Francois Hollande as
their new president, leading to fears that austerity measures would slow.
Aside from Greece, it was Spain that became the focus for markets.
Spanish bond yields surged in May, amid concerns that its banking system was
heading for collapse, while Moody’s cut the credit ratings on a swathe of
Spanish lenders. Europe’s leaders stepped in, pledging a €100bn bailout fund for
Spain’s banks, but with Moody’s subsequently cutting the nation’s credit rating
by three notches to the lowest investment grade rating, Spanish bond yields were
soon reaching euro-era highs, with 10-year yields exceeding 7%.
While
the ECB has indicated its willingness to contribute to solving the crisis, the
problems are unlikely to be resolved swiftly. Insight is of the opinion that
eventually European policy makers will do what they have to do to resolve the
crisis among the weaker euro countries. The victory of France’s socialist
candidate Hollande and recent events in Greece increase the potential for
measures which will encourage growth rather than purely focus on austerity.
While this may improve sentiment, as well as lifting economic growth at the
margin, it remains clear that European economic activity will be hampered both
this year and next.
If political leaders are able to turn their words
into action, then the crisis fears should recede and this may lead to a small
rise in core European bond yields, including bunds, over the next 12 months.
However, any rise is likely to be modest, and yields are likely to remain near
historic lows. In the current circumstances, Insight is of the opinion that it
would be wise to avoid low-yielding short-dated bonds, and peripheral market
spreads are expected to continue to be volatile in the near term.
Financials bear the brunt of rating downgrades
In
investment grade credit, caution and risk aversion dominated markets during the
first two months of the quarter, but risk appetite returned during June and
July, leaving spreads little changed overall. Given the swathe of credit rating
downgrades for banks, it was of little surprise that non-financials outperformed
financials, with property, consumer cyclicals and utilities doing particularly
well. Within financials, it was a two-track market, with bank bonds that
prioritise for repayment in the event of default, outperforming those lower down
the capital repayment structure.
Insight considers credit spreads to be
strategically attractive at current levels and with risk aversion gradually
fading, the search for yield is likely to encourage investors back into the
asset class. Defaults have crept up slightly but overall remain at the lower end
of the range. While there are reasons to remain strategically positive for the
European and UK corporate bond markets, in the short-term there is also reason
to remain cautious.
The risk remains in southern Europe, where the credit
market is likely to remain volatile. Following Moody’s raft of banking ratings
downgrades, Insight is of the opinion that it is an opportune time to analyse
financial bonds to find the best value. Correspondingly, this area has
potentially the most to gain from any increase in stability.
High
yield remains volatile
April 2012 was a relatively subdued month for
sub-investment grade credit, with institutional investors not inclined to add
any material risk given the thin trading volumes and increasing concerns about
the eurozone peripheral sovereign crisis. However, May 2012 was very weak, with
bonds with any association to the eurozone peripheries being negatively
impacted, irrespective of the company’s underlying fundamentals. June and July
2012 were more positive, and the market staged a strong recovery as investors
became more hopeful for a political solution to Europe’s woes.
Insight is
of the opinion that the high yield market is expected to continue to see spreads
narrow as institutional investors, who have built up cash reserves, put money to
work. They are continuing their search for yield and are moving into lower-rated
bonds to get it. Generally, with banks continuing to step away from lending to
corporates, more new issuers are expected to come to the bond markets for
funding. Peripheral issuers will continue to struggle in the primary market
until the political nervousness subsides. Insight is of the opinion that it
would be prudent to focus on companies that are in less cyclical industries with
robust cash flows that are more likely to hold up well despite weak economy.
April LaRusse joined the fixed income team at Insight in
September 2008 as a senior fixed income product specialist. She joined Insight
from F&C Investments where she was a portfolio manager responsible for
managing UK, US and global government bond portfolios. Prior to this she was in
government bond and derivative sales at Lehman Brothers. April began her career
as a government bond portfolio manager at Newton Investment Management. April
graduated with a BA in Economics from Mount Holyoke College, Massachusetts,
United States and an MBA from City University Business School in London. She is
also an Associate of the CFA Society of the UK. Together with the respective
fund manager, April is also responsible for the La Valette Monthly Income Fund,
La Valette Euro Income Fund, La Valette Sterling Income Fund and the La Valette
High Yield Fund, which are managed by Valletta Fund Management Limited.
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