We have just closed a year in which the returns for the main asset classes defied consensus expectations, largely because of the swings and shifts in investors’ sentiment that shaped the trend over the second semester. After a first semester in which complacency became the word of the day boosting the returns in the high yield market to over 5% and lowering the volatility in the stock markets, the second semester brought about a widening in high yield spreads (i.e. a fall in prices), a continuous fall in the US and Eurozone Government yields and more swings in equity prices.

The fall in oil prices was one of the main catalysts over the last few months, impacting multiple markets in different ways. In Europe, it led to renewed deflationary worries which pushed the 10 year German bond yield to record lows and hence contributed to the strong performance of the Investment Grade bonds. According to the Bank of America Euro Index, the latter returned about 6% over the second semester as they also benefited from speculations that the European Central Bank will be forced to buy government or corporate bonds; for 2014 the return for this asset class stood at a whooping 11%. In contrast the European high yield market had a weak second half-year reflecting the negative returns posted by the lower rated bonds (rated less than BB-); indeed, the re-emergence of the deflationary woes impacted negatively these names as many of these issuers operate in cyclical sectors and the demand for such products is due to suffer in a deflationary environment as the prospect of falling prices makes consumers delay purchases.

Looking ahead we note that barring a sudden reversal in inflation expectations, the European Investment Grade might be in for another year of steady returns as Japan’s example serves to show that the government yields in the Eurozone can go lower (the 10 year rate for Japan is at 0.3% whereas in Germany it is above 0.5%).  Relatedly, the Japanese corporate spreads are less than half of the European ones. As regards the European high yield market, much of the downside risks appear to be already priced in judging by the ratio between the spreads offered by B-rated and BB-rated bonds which has sharply increased over just a few weeks and reached levels higher than in 2008.

Moving on to the US fixed income market, the first thing to note is that the fall in oil quotes had a disproportionate effect on the local high yield market which has a greater exposure to the energy sector (more than 15%). Thus, the valuations in the USD space have fallen markedly over the last few months with moves extending to non-energy names after the high yield retail funds suffered large outflows during a period of low liquidity. As such the US high yield market underperformed the European one by a significant margin and the spread differential between the two markets increased to multi-year highs.  This in turn has led to an improvement in momentum as investors tentatively stepped in to lock in the opportunities created by the recent moves and take advantage of the higher yields on offer (6.6% versus 4.2% for the European names, if one looks at the Bank of America high yield indices). While the latter is partly explained by the longer average maturity of the US index, this might become increasingly trivial for investors in a world marked by falling commodity prices and lower growth. That is, over the past few months the inflation expectations in the US fell, as the dollar appreciation combined with the lower oil prices both put downward pressure on prices. As such, the long term US government bond rates have remained low and closed the year at 2.25% after opening at 3%. On another note, we highlight that, as it was the case in Europe, the fall in government yields supported the Investment Grade class which posted an annual return of 7.4%. Looking forward we think that the prospects of this asset class are reassuring as we consider the interest rate risks manageable and the spreads on offer attractive. More specifically, while we acknowledge that the US corporates are on the road for an increase in leverage and that the local central bank will not be a buyer in this market, we also note that the spreads here stand at 1.4% versus 0.5% in Europe; on a similar note, we often come across European names for which the USD denominated bonds carry a sizable premium over their EUR notes.

To close up, we think 2015 will be a year during which a correct assessment of the government yields prospects is critical for deciding the Investment Grade allocations whereas in the high yield sector the name selection is increasingly relevant.

This article was issued by Ms Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.