Assessing the 2012 bond market outlook presents a challenge for fixed income investors, since so much hinges on the evolution of the European debt crisis.
For most investors in bonds and bond funds, performance in the year ahead may well be determined by events that unfold in upcoming months.
The past year however, has been a positive one for fixed income. In spite of the eurozone crisis playing on every investor’s mind, the European bond indices have all made a gain. Even recent country downgrades announced by rating agency Standard & Poor’s have not had the negative effect that some might have predicted. This is probably because they were anticipated and already priced in by the market.
In fact, negative sentiment has encouraged inflows into the bond sectors, with more than £911m invested in bond funds in the year to January 31 2011.
This has helped performance, with the Merrill Lynch EMU All Non-Sovereigns 10+ years, Merrill Lynch EMU All Non-Sovereigns 5-10 years and the Merrill Lynch EMU Direct Government Bond indices making a gain of 4.55 per cent, 3.89 per cent and 2.47 per cent respectively, in the same time period.
Yields on eurozone bonds are at an all time low, showing that investors have some confidence in the ability of countries to pay back their debt.
Just as Italian bank bond yields spiralled upwards with the Italian sovereign debt, they have plummeted too, and banks have been able to issue bonds to the market again this year.
Jonathan Platt, head of fixed interest at Royal London Asset Management, (Rlam), says: “On a purchasing power parity basis, the eurozone accounts for just 15 per cent of global economic activity. However, on the basis of column inches in the press it accounts for close to 100 per cent.
“Given that our economic base case is modest global economic growth, continued deleveraging and conservative corporate behaviour, we see scope for credit spreads to narrow significantly from current levels and to move towards a level which better reflects underlying corporate fundamentals. Corporate earnings have been strong and have been used to cut leverage, with the appetite for expansionary capex being relatively low.”
Mr Platt adds that the key downside risk remains a disorderly outcome to the euro crisis, leading to corporate defaults and a freezing of credit markets, although he suggests that other risk assets may perform even worse in this scenario.
He adds: “It is already clear that everything must be done to prevent a disorderly break-up of the euro, since the complexity of interbank relationships would lead to legal and banking chaos. The intensification of the crisis has already pushed the eurozone back into recession.”
As a result of the ECB’s long-term refinancing operation (LTRO), on January 12 Spain set the ball rolling by auctioning ¤10bn (£8.4bn) worth of bonds, twice its original target. Yields on Spanish bonds maturing in two years dropped to 2.8 per cent, from a peak of 6.1 per cent in November.
Saving the single currency
Bryn Jones, fixed income director at Rathbone Unit Trust Managers (Rutm), says that the ECB’s LTRO is the first of several such measures designed to prevent a break-up of the single currency. The LTRO offers unlimited three-year loans at 1 per cent per cent to European banks.
“We expect another LTRO soon, which could lead to inflows into credit, covered bonds or sovereign debt. The ECB’s balance sheet is now bigger than the US Federal Reserve’s, so preventing a euro break-up becomes imperative.”
On Wednesday February 1 2012, the yield for Italian, Spanish and French debt was below 6 per cent, with France’s yield on government debt standing at 3.07 per cent.
The negative effect of this, however, has been that spreads or differences between yields have widened.
Thanos Bardas, managing director and head of global interest rates at Neuberger Berman, says: “If if you look at the investment grade, even in the US, where presumably the linkage to the EU is through trade effects amongst economies, credit spreads were about 70 basis points (bps) wider.
“We estimate 50 bps lower yield in government bonds, associated with worries about the crisis in Europe and the potential problems if the EU breaks up.”
Phil Milburn, manager of the £525m Kames Capital High Yield Bond fund, agrees, arguing that yields on high yield debt are overestimating the potential rate of company defaults in the asset class, creating further volatility.
He says that the actual default rate among high yield issuers in 2011 was roughly 2 per cent – less than half of the historical average of 4.9 per cent. He estimates the default rate across global high yield markets in 2012 will be between 3 and 4 per cent.
It’s evident to most managers that corporate debt looks a much safer bet now than before the Lehman Brothers crash, as companies are running with more cash on their balance sheets and leaner stocks. The stagnating growth in Europe has helped concentrate the mind and firms are more careful about their spending.
Some of the largest European high yield bond funds, such as the M&G European High Yield Bond, the Axa Pan European High Yield Bond and the Swip European High Yield Bond returned as much as 7.57 per cent, 5.98 per cent and 5.36 per cent respectively in the year to January 31 2011.
Nonetheless, because of big difference in yields between government bonds and corporate/high yield credit, there was a lack of sentiment in favour of corporate and high yield bonds in 2011, as investors considered them to be more risky. However, Mr Jones warns that while a Greek default or restructure has been priced in to government bond markets, what hasn’t been priced in is the chances of Italian or Spanish government debt defaulting or being restructured. This could, in his opinion, be a game-changer – turning the tables and putting high yield debt in a more favourable position.
He says: “The scene is set for risk assets to outperform during the first six months of the year, although a European meltdown or a serious oil price shock could still be a game-changer. The big risk for investors is being too bearish and missing the bright spots. A number of sectors such as high yield and financials are looking very attractive.”
Flight to equities?
The question is however, with negative sentiment – stemming from Europe – an apparent driver in the bond market, would a resolution in Europe actually be beneficial to the bond market, or will there be a flight to equities and alternative asset classes?
European-listed fixed income exchange traded funds (ETFs) saw relatively modest net outflows of ¤800m in 2011, but that masked big outflows from government bond ETFs and robust inflows of more than ¤1bn into ETFs in investment grade corporate bond and high yield.
Nizam Hamid, head of ETF strategy at Lyxor, suggests that fixed income flows had been highly variable over the past year, reflecting the Europe’s sovereign debt crisis. Investors had turned to corporate bonds as these offered a more balance risk/reward trade-off combined with higher yields, an important attraction in a low interest rate environment.
Mike Riddell, manager of the M&G International Sovereign Bond fund, says that if growth starts to pick up then government bonds could suffer.
“In May last year, government bond yields were more than 1 per cent higher than they are today and yield curves were much steeper. It was expensive to be short duration at the time. The situation has changed a bit since then, presumably because of eurozone stress and perhaps also because of China. If Europe is no longer in a downward spiral then government bonds really do look vulnerable,” he says in his latest blog.
But as Mark Parry, senior portfolio manager at Aberdeen Asset Management argues, that in order for the eurozone debt market to remain sustainable, these issues, as well as other problems surrounding competitiveness, will need to be addressed.
Simona Stankovska is features writer at Investment Adviser