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The bond market and the sustained monetary easing

It is to no surprise that the second largest asset class, the fixed-income market, continued its rally over the past days. Market expectations of increased monetary policy has pushed yields towards record lows with some analysts now questioning the relatively tight valuations primarily within the high yield market.

In the initial months of the year, market participants were concerned over the continued pressure of a rate hike in the US which adversely impacted the fixed income asset class, predominantly emerging hard currency debt.

Following the wave of quantitative easing in Europe and the prolonged easing stance by the Federal Reserve, which despite hinting for another rate hike, maintained a dovish stance, the reversal occurred.

As at today the fixed-income class has emerged as one of the prime winners as investors dashed into an asset class which was being solely sustained by the wave of easing, in addition to a risk aversion mode.

From a technical jargon perspective, as rates move lower, bond prices increase and thus yields decrease due to the fact that we would be discounting the expected cash flows at a lower discount rate.

That said the lower rate imposed at this stage, primarily by the easing measures, is capturing the macro element, while the extra spread being offered to bondholders is brought about by the so-called idiosyncratic risk, also known as specific risk which the issuer holds.

In actual fact, the spread which captures the specific risk, mainly for high debt issuers might have not improved as the sluggish economy is constraining demand.

That said an interesting fact, which I have mentioned a few weeks ago in one of my articles, is the fact that the lower interest rates have pushed high yield companies to exercise their call option and re-financing at ridiculously lower rates which in my view investors are not being paid in terms of risk-adjusted returns.

A case in point, is the latest issue by Telecom Italia, which issued a 3.625 per cent 2026 issue.

However, let’s be positive and play the market. The prime gainer within the asset class at this point in time are Emerging market bonds, primarily denominated in hard currency, which till date rallied by 15.4 per cent.

Let’s face it, whoever believed that in August 2016, the said asset class would touch such levels. In my view the prime reason for such low yields is that investors are fetching more attractive returns as the situation in Europe, in terms of returns is way below what investors would expect.

This could be also the case for USD issued bonds which are also amongst the headliners with a year-to-date gains of 14.6 per cent.

In my view, selective emerging market debt a few months ago were hugely undervalued. For instance, Brazilian issuers were heavily hit by the recent political turmoil. However, can we agree that Brazil is the largest emerging market economy and we can expect a recovery going forward? In my view yes and being selectively exposed to issuers there is definitely attractive. Case in point at this stage would be exporting Brazilian companies.

My concern going forward is whether the market is now pricing in a possible rate hike this year. If yes the fixed-income class would sustain the current levels. However, if not we might experience a correction, which from a technical perspective this should be warranted.

Other than that, current valuation in my view are quite tight, and seeking value at this stage is a huge concern for Asset Managers. So in my view investors should be aware of the current levels and accept the fact that the returns which could be generated three to five years ago are now no longer sustainable. So let’s be happy with the current levels of return when considering the current economic turmoil.     

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are 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 Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

 

 

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