Are we in a fixed income sweet spot?
Deleveraging has further to run
In the coming years, the positive environment for fixed income looks set to persist.
The deleveraging that began back in 2008 remains in its early stages, and has a long way to run. Debt levels in developed countries are still too high, and they will continue to come down.
As a result, yields on gilts and US treasuries may be expected to remain rangebound. Based on these assumptions, we expect to see the differences between yields compress in certain sectors of the fixed income market as investors are forced to take more risk.
The key to bond investing in this environment will be dynamic and active allocation between sectors. Given the positive market conditions, the decision for investors will not be whether or not to be in fixed income, but where best to allocate to take advantage of the opportunities.
Parts of the debt market that currently appear attractive include high yield, which continues to benefit from strong fundamentals. Companies are in excellent health, and remain very cautious about taking on leverage.
Default rates on European debt are low by historical standards, and are not expected to rise markedly this year.
Technical factors are also favourable, with companies finding it easy to roll over debt given the high number of investors entering the asset class.
Finally, valuations are attractive, with investors being well paid to take on the additional risk of investing in high yield versus investment grade credit and government bonds.
In the euro market in particular, there are real opportunities, with solid high yield companies in the core eurozone appearing to offer good value. Euro-denominated high yield bonds suffered last year from the general aversion to European assets that resulted from the debt crisis.
However, euro high yield issuers benefit from better average credit quality than their US peers, with a lower average sensitivity to monetary policy tightening and a higher average yield.
The liquidity injections from the ECB have served to weaken the euro, which is also good news for euro high yield companies, since many of them are exporters and therefore benefit from selling goods denominated in a cheaper euro.
Emerging market debt also looks appealing in the current environment. Bond investors are essentially moneylenders, and, like moneylenders, should be focused on the ability and the willingness of the borrower to pay. Assessing the global markets on this basis, emerging markets are simply better equipped to pay, given their lower debts and lower deficits compared with their developed market peers.