Notwithstanding all the market chatter that 2013 was certain to be characterised by the so-called ‘Great Rotation’ out of bonds (Investment Grade IG and High Yield HY) into equities, credit markets were more benign than expected with European HY bonds being the top performing asset class within the fixed income space, posting a 9.4 per cent total return, considerably lagging behind US and European equity markets which had a remarkable 2013 (18 per cent in Europe and 29.6 per cent in the US).
On the other hand, emerging markets and US IG corporate bonds posted negative total returns mainly on the back of persistent talk of the US Federal Reserve’s tapering intentions of monthly bond purchases.
For credit, 2014 started pretty much where it left off in 2013 with spreads continuing to grind tighter and the new issue market in full swing. The robust momentum witnessed in December 2013 coupled with a large number of bond redemptions in the first quarter of 2014 should keep bond prices well supported with the rally expected to persist, albeit at a slow pace.
From a markets perspective, following a haphazard past couple of years in terms of financial and political crises, lacklustre economic growth and more recently the complacency of markets to shun any negative news and interpret it as an opportunity to tag along with the credit rally, 2014 is expected to be a year of transition with investors moving on, leaving behind any sovereign worries and looking forward to signs of improved economic growth. Expectations are optimistic: a modest growth in the eurozone of 0.5 per cent and a significantly better one out of the US. Recent economic data releases in the eurozone are in fact indicating a slight improvement in economic conditions, but inflation remains worryingly low and unemployment stubbornly high at 12.1 per cent for an eighth consecutive month.
However, risks – most notably in the eurozone – remain evident. ECB’s Mario Draghi recently admitted that interest rates are expected to remain at current or lower levels for an extended period of time, hardly commensurate with an expanding economy. In this type of environment, therefore, credit markets could well post yet another year of positive performance.
The new issue market has already registered strong volumes across the board so far this year. In fact, as a result of the ultra-low-yield environment, many large corporations have taken advantage of the attractive (low) refinancing rates, thereby allowing them to improve their debt maturity profile by through the lengthening of their overall maturities at particularly cheap levels. This has ultimately resulted in a sharp decrease in default rates over recent years, despite the fact that most economies and corporations endured recessionary pains, significant in some cases. Moody’s recently issued its latest default report showing that the default rate in the eurozone was “only” 3.4 per cent as at the end of 2013, significantly below long-term averages, with this rate expected to drop to 2.1 per cent through 2014.
More meaningful, 2014 will see a large amount of bond redemptions (better known as bond maturities) and coupon payments which would need to be reinvested, adding further impetus to the case that the high yield segment could remain in demand for the large part of 2014. These bond redemptions could total up to €500bn. With such a flurry of supply, it can be easily argued that the risk of a rotation out of bonds into equities remains present. However, it is the large institutional portfolios which could keep bond prices supported for the majority of the year as the rotation we could witness is out of IG to HY bonds as a result of the continuous search for yield through the higher beta sectors within the bond market. Lower beta bonds are expected to remain under pressure in 2014; with low breakeven levels and their low yield environment, they are expected to suffer with rising benchmark yields.
2014 will see a large amount of bond redemptions (better known as bond maturities) and coupon payments which would need to be reinvested
Credit markets in fact got off to a flying start in 2014, with the end of year (2013) rally stretching on to the early trading sessions of the year. However, concerns in Emerging Markets (EM) resulted in a shift in risk aversion and a series of flight-to-quality trades that balanced both the spill-over impact of US tapering and the fear of rising interest rates. The US Federal Reserve’s decision to taper it Quantitative Easing programme lead a number of emerging market economies to face the daunting prospect of lower liquidity and increasing financing costs, leading investors to believe that this will result in weaker growth in EM economies. Moreover, weaker economic data from China, political unrest in Eastern Europe as well as a perceived lack of credibility of Turkey’s central bank have resulted in a marked decline in investor sentiment and optimism, which poor sentiment inevitably spread to equities and bonds.
Notwithstanding the bouts of EM-led volatility throughout the latter part of January and early February 2014, the global search for yield is expected to remain the name of the game, with HY bonds continuing to remain in demand, evidence that this asset class continues to form a growing part of investors’ portfolios.
In all this recent volatility, HY bonds have remained somewhat resilient. The preference for higher yielding bonds, higher beta names and sectors remains evident as the limited paper available is insufficient to meet the excess liquidity around. With earnings season beginning to gather pace, we could well see the demand for HY persisting. However, investors would not be at fault at this stage to err on the side of caution and take the recent rally in HY as an opportunity to begin to shorten the maturity profiles of their bond portfolios in an attempt to preserve capital and limit unnecessary portfolio fluctuations, albeit maintaining an exposure to this asset class as it continues to form an integral part of well-diversified portfolios.
This article is prepared for information purposes only and does not constitute investment advice or marketing communication. It does not constitute an offer or invitation to any person to buy or sell any investment or to enter into any business relationship with CC. This article is based on information obtained from reliable sources but which have not been independently verified. CC is under no obligation to update the information in this article. No person should act upon any recommendation in this document without first obtaining professional investment advice. CC does not accept liability for any actions, proceedings, costs, demands, expenses, loss or damage arising from the use of all or part of this article.
Calamatta Cuschieri & Co Ltd (C13729) is licensed to conduct investment services in Malta by the Malta Financial Services Authority.
The information in this article is valid as at February 6, 2014.
Mark Vella is an investment manager at Calamatta Cuschieri Investment Management.