More interest cuts on way
The volatility experienced in global bond markets over the last few months seems to have settled down a little now, and it is becoming clearer as to where the value is and is not.
While the focus switched to the US for the summer, all eyes are back on Europe, which is still a fragile environment in terms of economic growth. “There are encouraging signs that Euroland is about to turn around, but hard economic data pointing to a recovery remains elusive,” says Ulrich Katz of DIT Munich. Adding to the European Central Bank’s woes of slow economic growth, is the euro currency’s seemingly endless appreciation against the dollar. “If the euro continues to rise, competitiveness will be reduced in Euroland which is not an encouraging prospect,” says Gregor Macintosh, investment director at Standard Life in Edinburgh.
With growth below trend, and a runaway currency, it is not surprising that fund managers are forecasting further interest rate cuts out of the ECB. Just when the cut will come, and how large is will be, however, is up for discussion. Katz has pencilled in a 25 basis point cut for the first quarter for next year, and Macintosh equally feels it won’t be until next year. Charles McKenzie, head of UK fixed income at Deutsche Asset Management in London, believes the interest rate could fall to as low as 1.5% over the next three to 12 months. Hedge funds, however, are banking on a different story. They have reportedly been establishing positions to take advantage of a pre-Christmas cut. Whilst earlier than expected, such a move would not come as a total surprise – especially if the euro appreciated further, but with a new president on his way in, it is unlikely that such a drastic move would be made.
So what does all this mean for European bonds? Well, with growth below trend, low inflation and room for rate cuts, European bonds are generally well-supported. The expected rate cuts are keeping the front end of the curve protected. It is and in the belly of the curve that Katz sees the value. Especially given the steepness of the front end. “The pick up from two- to three-year is about 45 basis points, compared to just 10 basis points between the nine and ten year.” Macintosh prefers the five to seven year area as rate cuts have been priced in nearer the front. Jim Leaviss, head of retail fixed interest at M&G in London, still thinks there is value at the very long end, where the 30 year is yielding about 5%.
Outside of Euroland, Katz likes Sweden and Denmark. “From a fundamentals point of view, the economy is in much better shape in Sweden, and there is higher economic activity and a benign inflationary environment. The only concern is that the currency has appreciated a little too much. We also like the Danish market, where the currency is very stable, and there are still fairly attractive yield spreads.”
And if government bonds have the opportunity to perform well, then the news is good for corporate bonds, although fund managers agree that the levels of outperformance previously seen are not expected again. As Leaviss says: “It won’t be another bumper year.”
Underlying fundamentals remain positive for corporate bonds, and the Triple B/Single A story that has dominated the corporate bond market this year is continuing as the search for yield continues. The low interest rate environment and twinges of economic recovery mean that individual companies will be in a better position to pay back debt, and therefore default rates will fall further still. According to Leaviss, the default rate has fallen to 5% from 10% in the space of one year. High yield paper is being bought aggressively in Europe, say fund managers. “CDOs in particular are buying into high yield paper, and high yield deals are heavily oversubscribed,” says Andrew Sutherland of Standard Life.
But when selecting corporate bonds it is necessary to analyse each company in depth, says Leaviss. ‘Don’t look at sectors, but at individual bonds. You can’t afford to buy indiscriminately anymore – be more discriminating.” McKenzie agrees. “It is unlikely that one area will outperform.” Deustche Asset Management’s strategy lies with individual stock selection, and picking undervalued bonds.