For prudent investors, September’s precipitous trading in the major equity markets signalled the need to pull back positions and come closer to home. For Julius Baer Investment Management, this had entailed selling up certain emerging market bond positions. Edward Dove, chief investment officer, explains, “The declines in the equity markets last month made us uncomfortable and we decided to reduce the risk, by cutting our local currency bonds in Polish Zloty and South African Rand, for example. In terms of credit, we are sticking with them. “We believe that what we have is of high quality and that selling it would prove to be too expensive as they are illiquid at the best of times. Our portfolios are still long credit versus government with respect to our benchmarks, which tend to be entirely government.”
Dove adds that the coupon effect of these high yielding securities should be the significant contributors to returns in the sub-investment grade market. Indeed a recent study of the 20-year track record of the US Corporate Bond Market by Merrill Lynch revealed that, over most 5-year periods the incremental return was surprisingly close to the five-year average yield spread.
They do add the caveat, however, that the downside can be significant, pointing out that over the most recent five-year observation corporates have underperformed comparable risk Treasuries by about 50 basis points per year.
Although not invested in emerging market debt, the managers at Clariden have also been actively reducing risk in their portfolios. Martin Hueppi goes on, “We have been avoiding corporate bonds, or only buying short maturity debt, as the volatility increased across all the financial markets. We have been invested in the very long end of the US Treasury market from the start of the year, and this has been good for performance throughout.”
Even before the recent stock market sell-offs, Hueppi argues that volatility of credit spreads was already a feature of this year’s trading and made things much more complicated. He adds, “Event risks on entire sectors, like the telecoms, were very damaging to (interest rate) spreads and performance. Buying investment grade bonds is getting more difficult as credit quality is deteriorating and with that all spreads have been more volatile”.
DWS’s Johannes Muller agrees that it is right to be shifting back to governments, and particularly in a sector such as the telecoms. He goes on, “We know what the various companies are paying for their UMTS licences, and we know what they have borrowed already. And now we are just waiting for those shortfalls to be made up.”
Hueppi suggests that the ongoing equity market volatility and the tensions in the Middle East create an environment that is positive for very good credit quality such as governments and supranational sovereign or agency bonds.
“Take a look at swap spreads,” he argues, “which are a very good indicator for stress in the non-government sector, and we see that 10-year swap spreads have moved out from 105 basis points at the start of October to 122 bps two weeks later as tension has increased.”
After the quarter point rate hike at the beginning of the month, the ECB’c accompanying statement cited rapid M3 growth, high oil prices and the weak Euro as sources of potential inflation danger. Investors, however appear far more sanguine. Although monitoring the oil market, many investors believe that higher oil prices will not mean automatic bad news for fixed income markets.
“Oil is still important,” says Hueppi, “and the troubles in the Middle East may well push the oil price higher. Yes, inflation is related to oil prices so in the short term it is a negative, but I do not believe that this crisis will push the world into a bad recession. There has been a flight out of bonds in recent months and my guess is that this flight will reverse itself.” Clariden remain bullish on US and European bonds, and especially those of top quality investment grade, and argue that diversification across sectors is key to controlling risk.
Julius Baer’s Dove agrees, saying, “The dependency on oil of the western world’s economies is much diminished. Look at the UK where there is now a massive service sector economy. We think that higher oil prices will indirectly and directly be contributing to a much sharper economic slowdown.” Consequently, the Julius Baer team have been reversing their defensive curve shortening trades put on in September, and have repositioned their portfolios long of the benchmarks.