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January 12, 2014 7:23 am
Bond markets have become quite boring. For several months, the chief interest of the market has been the US Federal Reserve’s programme of quantitative easing. But the questions investors have been trying to answer are when the Fed would begin to wind down its asset purchases and at what pace.
There has been little doubt that they would be reduced sometime and that they will eventually stop. Nor can there be much debate about the future direction of wider monetary policy. Interest rates cannot realistically go down and at some point they will go up.
So, in all probability, core yields are going to rise and bond investors are going to face a headwind in seeking to generate returns. But there is still a job to do. Fixed interest is a core asset class, in part because it is an important source of reliable income.
Providing income is a challenge at the moment. We recently carried out an exercise to compare the income available in the market now and at the end of 2007. Looking at cash, government bonds and corporate bonds across the US, the UK and the eurozone, we estimate that at the end of 2007 there was a total $1.4tn of available income. Those same assets now produce annual income of $550bn. Nearly $900bn has gone. And the proportion of that income coming from “risk-free” sources has fallen.
Investors looking for real returns have no choice but to take some risk, and the market has become more risk tolerant. One sign of this is the increase in flows to bond funds. Lipper, the data provider, estimates a cumulative €600bn has been moved into bond funds in Europe since early 2010.
The key is to find the risks that are best rewarded. Notwithstanding recent weakness, it is hard to find value in duration/ interest rate risk. Core yields are significantly higher than a year ago and are back to where they were in the second half of 2011. But they remain very low in historic terms.
Based on the most recent core CPI data, investors need to buy Gilts and Treasuries longer than five years and Bunds longer than seven years just to get a yield that matches inflation. Given the five-year Treasury has had a total return of -2.9 per cent since the end of April, that does not seem attractive.
Demand for income has driven flows into lower credit quality assets. Credit-risk instruments carry higher yields but it is increasingly difficult, in my opinion, to find ones that offer clear value. These are good times for corporate treasurers.
The sterling investment-grade corporate bond market gives a yield spread of 1.4 per cent over Gilts, the lowest we have seen since 2007. The European high-yield market yields 3.6 per cent over government bonds, but this is also a post-2007 low. The default rate remains low but the huge support we have seen for this market is resulting in deterioration in issuance quality. The proportion of new high-yield issuance for the purposes of leveraged buyouts, acquisitions and dividends has risen (although it is still far lower than in 2006).
When yields are falling, we need consider where this reflects fundamental improvement rather than just market sentiment. The area where I think credit is still best supported is bank capital.
The banks are better credits than they were, with stronger balance sheets and access to government liquidity schemes. Progress on implementing Basel III and on a single European banking union will provide more support. So I can see a rationale for the lower yields and spreads in this sector.
But this is an increasingly diverse area. The debt instruments banks are issuing to meet their new capital requirements are significantly different from legacy subordinated capital. Some offer value, in our opinion, but they carry the risk of capital writedown or of conversion to equity on unattractive terms. They have to be handled issue by issue and with care. Subordinated bank capital is expected to be the biggest net positive area of credit issuance in the coming year, so analysis of these securities is going to be a crucial part of our job.
The bond markets have been good. We have seen really strong demand for income and very accommodative monetary policy. This has resulted in high valuations. Although these props are likely to remain in place for some time, it is hard to see where a further boost to the market could come from. And that is why things feel a bit dull for bond managers right now. We are waiting for the next stage of market evolution, when the next set of opportunities will appear.
Paul Read is co-head of fixed interest at Invesco
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