The prediction of many corporate bond market strategists is that 2014 will see continuing economic recovery, modestly rising government bond yields and narrowing corporate bond spreads. This would suggest a positive total return for the asset class, albeit not to the extent seen in past years.
Don’t take this outcome for granted, though. The massive build-up of debt that caused the global financial crisis has not been remedied and the current calmness could prove temporary. Tackling this debt mountain remains the biggest challenge that the global financial system must overcome and will have profound implications for fixed income investors.
Money creation happens when a loan is made, and the more loans, the more money is created. In normal circumstances, this process works well and banks have no qualms about lending.
Something extraordinary has been happening, though: loan growth has stalled, but deposit growth has continued surging upwards. Central banks have created money via quantitative easing, bringing billions of dollars into existence at the press of a button to fuel a massive post-crisis spending spree. It is hard to maintain good fiscal discipline in the face of a tidal wave of money. As the money builds up, it becomes more difficult to invest it in worthwhile projects, so growth slows as debt continues to pile up.
Realistically, there are only three ways to solve the problem of having too much debt. The ideal method is to achieve enough economic growth to compensate. Some countries are better placed than others, with the US standing out as a potential winner. The eurozone, by contrast, has been hampered by an inability or an unwillingness to centrally finance government deficits.
The second solution is inflation, which will steadily diminish the real value of the debt. This is difficult to generate in a controlled manner as any sign of inflation leads to higher interest rates that suppress economic growth and raise the cost of debt.
The third solution – and last resort – is to default on the debt, which has far-reaching negative consequences.
The road back to global financial health is therefore likely to be a long and bumpy one. One way to effectively cope with this uncertain environment is to use hedging strategies. More specifically, hedging can be used to focus risk on to parts of the market where the manager sees the best risk/reward potential, while removing exposure to areas that seem overvalued or where the tail risks are too great.
Any resolution of the debt mountain will create significant volatility, but it could also provide attractive opportunities for those who are brave enough.
Ben Bennett, head credit strategist at Legal & General Investment Management
Hedging
Ben Bennett, head credit strategist at Legal & General Investment Management, notes there are many ways to implement hedging.
“This [hedging] doesn’t necessarily mean reducing overall portfolio risk, although that’s certainly a valid approach. Perhaps the most straightforward way is to asset allocate, taking under- or over-weights to different parts of the market, but hedging can also be achieved by holding Credit Default Swaps on specific bonds, as well as more sophisticated derivatives arrangements.”
