US takes over the running
It has been a hectic time in the global fixed income markets over the past month, with the US putting itself firmly back on the map. Much of the interest had been focused in Europe this year, as Treasury yields hung below those of their European and UK counterparts, but events in the US over the past month have triggered large market moves, with knock-on effects noted in other regions of the world.
Up until the Federal Reserve rate cut in June, Greenspan’s message had been rather unclear. There was talk of a sluggish economy, fears of deflation, the possibility of buying bonds and zero interest rate policies, and one had the sense, says Chris Wozniak, director of fixed interest for Henderson Global Investors in London, that “the Fed was thinking out loud.” The doom and gloom, and downright uncertainty had created something of a bond market bubble, and at their lowest, 10-year Treasury yields had sunk to 3.06% . After the rate cut, however, the message from the Fed began to change. All of a sudden, Wall Street was hearing that the economic growth outlook was ‘optimistic’. Greenspan changed tack, citing growth on the way, and deflationary pressure to be off, and macroeconomic data out of the US in the form of GDP, and non-manufacturing, supported his optimism. Fund managers hastily changed their interest rate views, and just like that, the bubble burst.
US Treasuries saw their sharpest rise in yields in 22 years, as panicked investors sold off left, right and centre, pushing yields up to 4.55%. Although European government bond yields did follow those of US Treasuries on the way up, the rise was less spectacular – from around 3.5% to 4.2% for the 10-year. (See chart below for combined French, Italian and German government bond yield movements since June). “The general view had been that Europe was the better place to invest as yields were higher there, but suddenly it was the other way around,” says Wozniak.
Fund managers are therefore touting Treasuries for the long-end bet, although some are warning that the panic was overdone. “Equity markets have not really reacted, and while we are hoping and waiting for them to rise further, if they don’t, then we will surely see a back-off in yields,” says Peter Faessen, senior portfolio manager at Van Lanschot Investment Management in Den Bosch. It is certainly a difficult call, however. In Merrill Lynch’s August fund manager survey, the majority of those polled plumped for higher yields in 12 months time.
At the short-end, the US sell-off was driven by interest rate predictions. Prior to July many investors were under the impression that the central banks in Europe, the UK and the US were either in the process of easing monetary policy, or at most keeping rates on hold. Either way, rate rises were considered to be a thing of 2004 if not 2005. Having invested heavily in short-term paper, news of an economic recovery and therefore a potential rise in interest rates was enough to spark a heavy liquidation of short positions, and the two-year Treasury saw a rise in yield of about 80 basis points. It is here at the short end, however, that Europe is holding up its own. While the US economy is showing signs of recovery, and the interest rate cycle seems to have troughed, Europe is still struggling to keep its head above water. Predictions for economic growth in Europe are being retained to the long-term, and a further interest rate cut from the ECB is mooted for October in spite of hawkish comments from the central bank. “The rise in yields for the Euro-zone is a little overdone. While there is not much value at the short end in US Treasuries, the short end of the Bund curve looks relatively attractive,” says Faessen.
The corporate bond market has also seen its well-predicted bubble materialise and burst. “Until the end of June whatever you touched in terms of corporate bonds was fantastic. There was outperformance in all sectors, and it didn’t matter what came along, you bought it,” says Allan Valentiner, director of fixed income at Johannes Fuehr Deutschland in Frankfurt. The sell-off in government bonds spurred the similar and deeper sell-off in corporate bonds, but all is not lost. Fund managers are still insistent that companies should be using cash to repay debts and rebuild balance sheets, rather than on capital expenditure, and with default rates coming down, one would think the corporate bond market will remain supported.
The high yield and emerging market debt have also seen their days in the sun come to an end with substantial profit-taking being the key driver. This isn’t to say that these asset classes won’t continue to provide relative value either, but the levels of outperformance seen over the last year are not likely to be experienced again. Even those teetering on non-investment grade, Triple Bs, are having their value questioned.
Says Vallentiner: “The spread between Triple A credits and Triple B credits has tightened from about 300bp to 150bp, and this is overdone. There should be a higher risk premium for Triple B credits as they are more likely to default. I would say that 150bp as a risk premium is insufficient.” In terms of sectors, autos and utilities remain unpopular, and it is still the financials that are attracting interest – although this tends to be restricted to US and UK financials.
Not much has changed with regards to strategy, however, and focus is still on individual company fundamentals Focus on individual names, and then take profits on those names who have become too expensive over the course of this year,” advises Faessen.