Government bond downside risks now outweigh upside risks, says Western
Mike Story is London-based product specialist at Western Asset Management. The firm is part of US asset manager Legg Mason and manages the Legg Mason Western Asset Global Multi Strategy Fund. Story joined Western Asset in 2004. Before that, he worked for First Federal Bank and the Federal Reserve Bank of San Francisco.
What's your broad view of the bond and credit markets globally at present?
Bond-market developments in recent months signal a number of shifts that will be themes in fixed income over the next couple of years. Following their strong run over the past 15 years, government bond markets have reached a point where further declines in sovereign bond yields are unlikely.
At the same time, credit markets have exhibited more differentiation in terms of sector and issue performance. This contrasts with recent years, when investors initially pulled their money out of the credit market in 2007 and 2008, with little reflection of underlying fundamentals, and then saw a broad-based recovery in 2009.
These shifts mean that investors need to focus on interest-rate management as well as spreads in future. In addition, a manager's skill to add value through issue selection and sub-sector rotation is becoming increasingly important for the generation of returns in credit.
Can you talk more about government bonds in particular, in view of the big concerns in these markets, in particular for European countries.
While credit and liquidity concerns have dominated market sentiment over the past two to three years, concerns over sovereign risk have moved into the spotlight in 2010. Indeed, investors are questioning the long-standing assumption that government debt issued by developed economies can be considered a risk-free asset class.
Following the unprecedented scale of the monetary and fiscal support measures implemented in late 2008 and early 2009, concerns over the increasing issuance of debt by governments, the inflationary impact of the support measures on the global economy and uncertainty over the timing of potential interest rate hikes have led to increased volatility in government bond markets. These factors are likely to continue to affect government bonds for some time.
Clearly some countries are better off than others -- to what extent is that being reflected in investor behaviour?
Although government finances are generally deteriorating in developed countries, some countries are better equipped to deal with the increased expenditure than others due to more favourable debt-to-GDP levels or more prudent fiscal policies.
For the first time in years, markets have begun to reflect this by differentiating more between government issuers. Countries on the periphery of Europe have suffered in particular, with their sovereign bonds moving more in line with risk assets than the core European government bond markets. For bond managers, this differentiation has created more opportunities to add value.
Yet these developments are not only relevant for investments in government bonds. Over the past 10 to 15 years, credit investors have been used to a general downward trend in government bond yields. To generate returns in credit, this meant that investors only needed to think about relative returns compared to government bonds -- that is, credit spreads -- not the total yield.
However, with government bond yields more likely to rise than fall, in future investors will need to focus on both components of the total yield -- the government bond yield and the credit spread. Indeed, given the increased volatility in government bond yields generally, interest rate management will be key in delivering positive total returns in credit funds.
How about corporate bonds? You were overweight developed-market corporate bonds in December -- what is the situation now?
The credit sectors continue to offer the most attractive investment opportunities in fixed-income markets, in particular corporate bonds. Although corporate-bond valuations have improved significantly compared to a year ago, the case for these instruments remains strong, as valuations remain attractive by historical standards. The spread, which reflects investors' view of corporate risk, still accounts for a relatively large proportion of total credit yields. As the global economy and corporate earnings recover and default rates fall, we expect to see further gradual improvements in corporate spreads over 2010.
In stark contrast to government finances, corporate balance sheets continue to improve, corporate leverage has been reduced and liquidity levels have improved. Yet, despite robust and improving fundamentals, both investment-grade and high-yield corporate bond valuations imply relatively high default rates compared to previous credit cycles, and we think these default expectations will not materialise. In the US high-yield market, for instance, default rates peaked in late 2009 and have already started to come down.
As default rates recede, corporate bonds should continue to perform relatively well, at a minimum outperforming government bonds. Should the economic recovery gain a degree of durability, pricing on risky assets could rise further.
It seems, then, that corporate bonds are the place to be, so what strategy should investors follow?
Despite the potential for good returns on corporate bonds, valuations are no longer compelling across the board. While all credit sectors performed well in 2009 and exposure to any credit sector allowed investors to participate in last year's market gains, markets have started to differentiate more between bond sectors and issuers in recent months, and investors will therefore need to be more selective.
The next year or two are likely to be similar to 2005/2006, when there was a much greater dispersion in returns between the best and worst performers in credit sectors than in more recent years. Issue selection and sub-sector rotation will therefore be key to delivering positive returns in the next phase of the bond-market recovery.
Do you have any specific recommendations for the investment-grade market?
In investment-grade corporate bonds, we continue to favour the financial sector over the industrial and utility sectors. While we recognise that the bank-reform proposals announced in the US and related discussions across Europe have added considerable uncertainty to the future of the banking sector, tighter regulation should be viewed as inevitable and result in banks' balance sheets becoming less risky.
While this is generally negative for equity holders, it is actually positive for bond holders. In addition, we view the recent scaling-down of emergency liquidity facilities by the US Federal Reserve and the European Central Bank as a signal of liquidity and solvency improvements within the banking system.
And how about high yield?
The high-yield sector, meanwhile, had its strongest year on record in 2009 and is unlikely to repeat this kind of performance over the years ahead. However, we continue to see value in the asset class, although more in terms of income generation than likely capital gains. As in investment-grade bonds, issue and sector selection are going to be important. We are currently seeing opportunities in BB-rated bonds, in particular those securities that have a reasonable chance of being upgraded to investment grade within the next year.
To conclude, credit sectors remain attractive. But the trick is to keep one eye on interest rates, while selecting those bonds that are likely to perform well.