Investors flooded into bonds last year as cash investments paid next to nothing and fear of equity volatility remained acute. US investors for example allocated a record $396bn (€281bn) to bond funds in 2009, massively bigger than inflows into other asset classes, according to research firm Strategic Insight. Taxable bond funds had the highest net inflows in 2009, at $324bn, followed by equity funds with $75bn and emerging markets funds with $55bn.
Investors were handsomely rewarded for their faith, as the total return for bond funds averaged 17.5 per cent, according to Morningstar. The best performing sector was high yielding corporate bonds, which made an average return of about 47 per cent over the year. Their spreads widened to an almost unprecedented 1,930 basis points (bps) over gilts in March, as the market priced in massive default levels and banks tried to clear dodgy assets from their balance sheets, but the panic soon began to subside, prompting a massive rally. Those spreads came back to almost pre-crisis levels, but have recently opened back up to 644bps.
Although new bond funds are still being launched to attract those who missed out on the first rebound, a bond bubble could be developing. A raft of difficulties lie ahead, from Greece’s fiscal deficit to regulation for US banks, and last year’s appetite is also mellowing as corporate earnings growth shifts attention to equities.
As the mood changes, investors are stepping up their demands in the corporate bond market for a higher coupon and improved covenants. Companies such as football club Manchester United and Morgan Stanley have already begun to offer price concessions to tempt bond investors, after BMW and Vodafone weakened in secondary trading and Texas-based energy pipeline operator Energy Transfer Equity abandoned a £1.09bn (€1.25bn) sale, citing market conditions.
On the supply side, the wheel is also turning. 2009 saw record bond issuance as companies that traditionally relied on bank loans turned to the bond markets. This year the banks themselves are expected to issue a lot of debt, but the rest will depend on how many companies look to refinance bank loans with bond issuance and the extent to which mergers and acquisitions occur.
“We think there are three important and interrelated drivers in bond markets,” says Nigel Jenkins, principal and strategy director at Payden & Rygel. “The first is what will happen to short-term interest rates, the second is what will happen when the central banks, particularly in the UK and US, stop buying bonds, and quantitative easing ends, and the third is what will be the consequence of the huge budget deficits when the natural buyers of bonds sold to cover deficits dry up.
“All that is in addition to the prognosis for the global economy, where our central case is that growth around the world will be positive but somewhat sub-par in most regions, perhaps 2 per cent for developed countries and 3 per cent-3.5 per cent if emerging markets are included, but we do not believe we will slip back into recession.”
The biggest challenge for the UK is undoubtedly government debt which has built up rapidly and will hit 77 per cent of gross domestic product in 2014, while at the same time the economy is overexposed to the crippled financial sector. The City is clamouring for real action to reduce the UK’s deficit, and investors are nervous that political posturing ahead of the election is wasting valuable time.
Gilts are “resting on a bed of nitroglycerine” according to Pimco co-founder Bill Gross, who believes that if the government does not hasten its current plan for reducing the deficit, there is a strong likelihood that the UK will lose its AAA credit rating. A debt downgrade may also deter international investors from buying gilts at a time when the government needs to issue a record number. Mr Gross considers Canadian and German government bonds are safer, most liquid, alternatives.
Fear that interest rates will rise this year seems to be dissipating, but if they do, gilts will be most affected, particularly those with maturities of 10 years or more. “Short-term rates will stay low, and probably not rise for the whole of 2010,” predicts Joost Van Leenders, an asset allocation specialist at Fortis Investments, who is underweight government bonds and does not anticipate a sell-off, but remains “concerned about the risk of higher financing needs in the UK, US and peripheral Europe”. “Bond yields can’t rise much without having an impact on mortgages and the central banks will keep short-term rates where they are as long as possible,” he adds. “Certainly, the Fed won’t want to raise rates before it sees effect of its latest bail out of Fannie Mae and Freddie Mac.”
The ending of quantitative easing means government funding will have to be financed without the assistance of the Bank of England, which had bought nearly £200bn (€230bn) of gilts by February, inevitably creating inflationary pressures. Foreign investors account for around
30 per cent of UK gilt buyers, and the coming together of these conditions could undermine their confidence and cause sterling to weaken, further exacerbating the inflation risk.
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The potential for inflation splits the market. Nick Gartside, manager of Schroders’ strategic bond fund, is convinced “inflation will result from the extraordinary fiscal response in 2009. That will surprise the market, which has a lot of catching up to do. At the start of 2009 the street thought CPI would be 0.5 per cent, but it accelerated to 2.9 percent in December” |
The more prevalent view is that the high level of unemployment and general slow growth across the globe is dampening the threat. Paul Brain, investment director at Newton, says there is a possibility for inflation to creep higher because energy prices have
