Rocky road through 2003
To compare yields from the beginning of 2003 to those of December, one would be forgiven in thinking that this year has been a non-event in the fixed income market. Indeed, 10-year Treasuries commenced the year yielding 3.8%, and are now only about 4.5%. What has happened in the period in between, however, tells a very different story, and in the words of Marino Valensise, head of fixed income and currency at Baring Asset Management in London: “It’s been a rocky ride.”
The deflation/inflation story dominated the year’s proceedings with the Fed successfully confusing the world as to which way it was headed. For the last 30 years, central banks had only one goal – to fight inflation. So when Greenspan remarked on avoiding potential deflation in the first half of the year, participants were left scratching their heads. Hints at buying Treasuries across the curve in a bid to bring down yields and stimulate the US economy resulted in investors rushing out to buy bonds. By July, however, all thoughts of deflation were forgotten, and investors were left disappointed by a 25bp rate cut in the summer, leading to a sell-off. It is difficult to say that 2004 will be any smoother in the US. While some economic data appears promising, unemployment remains high, consumer saving remains low and balance sheets are still in need of repair. “It is going to be interesting to see what happens in 2004, “ says Sylvain de Ruijter, head of OECD fixed income at ING Investment Management in The Hague. He doesn’t think it will take much bad news for the markets to be nervous about deflation once again. “A few more strong quarters followed by a slow down and people will realise that inflation is still low and will start worrying again.” And the Fed has made it clear that it is in no hurry to start increasing rates. Indeed, the ECB looks more likely to raise rates first, making US Treasuries the more attractive bet for 2004. This year, European government bonds outperformed their US counterparts as economic growth rate continued to lag. Now, however, “recovery is taking hold, and we are seeing more robust data confirming this,” says Christel Rendu de Lint, fixed income fund manager at Pictet Asset Management in Geneva, who believes 10-year Bund yields will remain in a range of 4.2% and 4.5% in the short-run, but should then climb higher.
Within the European government bond market, index-linked bonds moved into the limelight in 2003. “For a long time, it was a bit of a mickey mouse market in continental Europe, but that’s changing rapidly,” says de Ruijter. “There has been an explosion of interest from continental European pension funds and institutional investors, who have lost money on equity markets, and are now becoming risk averse. UK pension funds have had large shares in inflation-linked bond for many years, but now consultants in other countries are advising an increased allocation. We’ve seen issuance from Italy, and there is talk of issuance from Germany – it could well be a theme for 2004.”
In the investment-grade corporate debt market, 2003 was “a phenomenally good year” and spreads have contracted massively. In the individual sectors, industrials have enjoyed the best performance, and within that sector, telecoms, according to Irène D’orgeval, head of active fixed income management at CDC Ixis Asset Management in Paris. “Telecoms have returned roughly three times as much as governments – about 9%,” she says. The lower-rated investment grade bonds, namely the Triple Bs, also had a good 2003, and the trend is expected to continue for the first half of 2004. After this point, sustainability will become questionable, believes D’orgeval. “Credit quality is still improving, and Moody’s shows that the ratings deterioration trend bottomed on in the first part of 2003. We have, therefore, seen an upturn and think it will continue given the improving credit profiles of all sectors except automobiles.” Value is now fair in the credit market, admits D’orgeval, so going forward the focus will be more on relative value opportunities, and buy on dip strategies.
In the high yield market, 2003 has also been an extraordinary year, up 23% in Europe year-to-date, with similar performance in the US. Says Barry Jones, portfolio manager at high yield specialist, Muzinich: “It has been the best year since 1991 – certainly from a US perspective.”
Default stories have remained minimal, and unsurprising – being names that had barely made it through 2002. Jones believes issuance to have been better, and investors to have been more demanding in terms of covernants and amounts of leverage, resulting in a healthier market.
The profile of the high yield market has also been increased by the fallen angels. Focus has indeed been on the household names which have fallen down from investment grade into the high yield arena. Corporates such as Ericsson, Alcatel, ABB, and Invenysys have brought both liquidity and attention to the high yield space. As investors dropped the paper as it fell, the oversold market made high yield look attractive and also sparked new interest.
With more liquidity, more household names, and fewer default cases, high yield has also become a more acceptable asset class, expanding the investor base. “Continental European and Scandinavian pension funds have been traditional investors, but we’ve seen increased interest out of UK pension funds, and hedge funds,” says Jones.
Going forward, Muzinich is positive that the market will continue to do well. “We’re expecting yields to tick along more at coupon type levels next year, and the heightened profile will drive new issuance which makes for a healthy market going forward.
“The obvious names have fallen, but there is till scope for more fallen angels – for some names there are clearly difficult times ahead. And those that had fallen we’ll see refinance and address balance sheet. 2004 is likely to be a ‘follow-on year’ from 2003.”
Emerging market debt has fared well in 2003, up around 26% on the year, and, like high yield, has seen its investor base widen, particularly from Scandinavia, says William Ledward, portfolio manager at Fiduciary Trust in London.
In terms of individual bets, Brazil and Russia dominated the market. “Brazil made a return from the dead, and is now up around 55% year-to-date,” says Ledward. Adds Valensise: “In October 2002, Brazil was trading at distressed levels as market players were fearful of the election of Lula, but since then has delivered 100% returns.
Investors considering Russia now will also have missed the boat. Although it returned well in excess of 150% during the post-default period, some volatility from the Yukos scandal and the tight spread levels make us believe that “there is no juice left”, says Valensise.
Mexico, Ecuador, Nigeria and Urguay have also performed well over 2003, while Dominican Republic, with the collapse of the currency and banking problems, has fared worst, with negative returns of 14%.
Fund managers are not as positive that the high returns of this year are sustainable, however. Yields are now at historical lows, and Ledward warns of investing by looking in a rear view mirror. “While performance was good over the first half of the year, the asset class has just trodden water over the last four months, and the best case scenario for next year would be returns of 10%,” says Ledward. Indeed, emerging market equities look more promising.