Ian Edmonds and Mike Story are London-based portfolio managers at Western Asset Management, which manages around $473 billion worldwide. Ian and Story share with AsianInvestor their views about the global bond market.
Do you believe the recent rally in non-government bonds is sustainable?
Story: During the crisis, investors flooded into money market funds in a safe haven bid. They have only gradually begun to reallocate towards riskier asset classes. We do believe there is still a lot of money sitting on the sidelines and that this rally does have some time to go. As investor confidence improves and with cash returning next to nothing at current rates, we do believe investors will become more willing to redeploy their cash in riskier market segments. However, we are not expecting a very smooth narrowing in spreads on non-government bonds and do expect to see setbacks, as markets continue to be extremely volatile
Where are you seeing the best opportunities in fixed income at the moment?
Edmonds: For investors who have been sitting on the sidelines in safe haven assets and are taking a first step into non-government bonds, we think investment grade corporate bonds currently offer the best risk-reward trade off. Valuations are very attractive, with overall yields on the asset class at historically high levels compared to government bonds yields. Market technicals have become more positive.
Companies are coming back to the bond market to raise capital as they can't rely on banks anymore for term funding. The issuers are willing to pay an extra premium to give more yield to investors and to be able to attract investors and get access to the market. Demand is picking up as well, helped by asset allocation shifts from pension funds into credit. We also believe valuations still reflect excessive default rate expectations, especially given the relative soundness of companies' balance sheets. There will be sectors that continue to struggle, such as chemicals, auto suppliers and auto manufacturers; these are areas where we remain cautious. We like pharmaceuticals, telecoms, cable, certain utilities and energy and mining companies.
High yield has seen a strong recovery in recent months. Do you see that continuing?
Edmonds: High yield is an area where we haven't seen much supply and there hasn't been a lot of inventory, so we've seen prices run up pretty quickly when demand for the sector picked up. The January rally started with companies that people felt they knew best and seemed to be generally sound and it was the more distressed sector that lagged. However, the latter sector did start to recover later on. I don't think the sharp narrowing in spreads will continue to the same extent. I believe the market could stall over the next few months and I see the income perspective of the asset class becoming more important.
Financials have similarly started to turn around. Are you encouraged by the results of the stress tests announced in the US recently?
Edmonds: During the first quarter, there was still a great deal of concern about the viability of banks and fears of potential nationalisation and coupon deferrals. To put into perspective how volatile subordinated financial debt has been, the decline in the asset class over the first quarter was as large as that recorded in 2008 as a whole. The results of the stress tests of the largest US banks, conducted by US regulators, suggested that the challenges facing those banks was manageable and that the capital needing to be raised was less than feared. That lifted confidence in the sector, leading to a recovery in the bond market in recent weeks. Banks are trying to improve their balance sheets, which should improve the credit quality of the financial institutions and give investors increased confidence to take on subordinated credit risk.
However, at the moment, the market for subordinated bonds remains very illiquid. What happens to the asset class in the long run will depend on the decisions the regulators, the governments and the industry itself make with regard to the role subordinated capital should play in banks' overall balance sheets. In terms of our own holdings, we continue to evaluate every single financial institution on its own merits and the bonds' valuation. If we think that we have an opportunity to sell a bond and buy another asset class or bond that offers better value, then we will do that.
Have you been finding opportunities in emerging market debt?
Story: From a risk/reward perspective, we feel that US dollar-denominated sovereign markets remain fairly expensive. Our focus continues to be in the emerging market corporate space. Typically our focus is on resource companies, quasi-state owned companies, major banks and telecoms. A lot of these companies have strong links with the state, so we think they should have access to capital if the need arises. In local currency markets, we sold Hungary early in the first quarter as we felt that the currency was likely to come under pressure. Our focus really remains in Brazil and Turkey now.
What is the biggest lesson you have learned over the current crisis?
Edmonds: One of the features of the crisis is that all non-government bond sectors became correlated in terms of their negative performance. Certainly one thing we found was that having more exposure to government bonds would have helped a bit, as we were underweight government bonds during the flight to quality, although this wouldn't have protected the investor from a total return perspective. We could have perhaps been quicker to realise that the non-government sectors were all going to be correlated. That being said, we did cut back risk in the emerging markets and if we had cut back high yield towards the end of 2008, we probably would have been struggling now and the funds wouldn't have benefited from the total returns generated this year. In subordinated financials, we added exposure in late 2007 and early 2008, which with hindsight was too quick. We did not think it was a massively risky position when we put it on, but it turned out to be that way. Quite frankly we didn't forecast the failure of Lehman Brothers and the collapse of the banking system.
Are you still optimistic about a rebound in economic growth later this year?
Story: Looking back, we think there are two distinct phases to the recent growth slowdown. We believe a growth slowdown was already present before the financial crisis escalated in late 2008. This was exacerbated by the complete collapse in economic activity after Lehman Brothers failed. Manufacturers scrambled to raise liquidity and could not raise that in the private sector. In the absence of credit, production has been put on hold and inventories have been dramatically reduced. With liquidity conditions improving, the drawdown in inventories and its resulting drag on economic growth is beginning to abate and we are optimistic that growth will continue to rebound.
We believe there are signs that the economy is starting to stabilise or the rate of slowdown in growth is, at least, declining. However, we're not extremely bullish on growth. We think that growth will come back to levels that are positive but certainly not back to the levels that we had been accustomed to before the crisis hit. In other words, we expect sub-trend growth for the next few years as the economy undergoes this convalescence period. However, we believe that all that is needed for credit and asset prices to recover is some sense of stability in the economy.