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Avoiding Red October and beyond

September has seen two central bank meetings, an oil agreement struck and persistent uncertainty surrounding Brexit and the upcoming US elections.

Throughout the month, the bond market generated mixed returns across the board, with the BOFA ML European High yield index dropping by circa 43 basis points and spreads widening compared to the U.S. BOFA ML High yield index, which conversely gained circa 64 basis points, experiencing tighter spreads.

The widening of spreads in the Eurozone was predominantly the result of inaction taken by the European Central Bank (ECB) in the meeting held September 8, with the primary laggards being long-dated sovereigns from peripheral areas.

The inaction by the ECB triggered uncertainty on how monetary politicians will move forward. In addition, the Brexit referendum outcome, was still looming on investors’ sentiment due to the material impacts on the Eurozone area, which are still relatively unclear. More clarity may come through once article 50 is triggered in the early months of 2017.

Having said that, Eurozone yields could be expected to tighten going forward, based on the possibility the ECB acts by adding further stimulus, after failing to do so in September’s meeting.

In U.S. High yield, performance was boosted by oil’s rebound of circa 8% for September following an agreement towards the end of the month to cease production between major oil producers. The agreement came as a surprise to markets following the numerous stalemates in preceding negotiations.

The energy sector has a high weighting in the U.S. BOFA ML High yield index and contributes a good chunk of the positive performance seen in the index. The other boost for the said asset class was the inaction by the U.S. Federal Reserve, which maintained interest rates at current levels on the 21st September, despite setting the tone for an increased possibility of a rate hike in subsequent meetings. Objectives of maximum employment and price stability continue to be monitored.

Emerging market positions would also benefit in being monitored in line with the increased probability of a December rate hike. An appreciating USD would negatively impact emerging market companies whose primary funding currency is the U.S. Dollar. With the majority of corporate operations in local emerging market currencies, an appreciating dollar makes it more expensive for such companies, already fragile following the past year’s commodity crisis, in repaying their debt dues.

Over the next few weeks, election fever in the U.S is bound to spark further volatility, predominantly via inflows into investment grade sovereigns leading up to the election, as investors take on a risk-averse cautious stance until a comforting outcome is known.

Although Investment grade bond issues may benefit the investor in weathering election uncertainty over the short term, in the longer term, the longer end of the investment grade yield curve faces substantial widening of spreads once interest rates eventually do increase, leading investors into moving into higher coupon issues or conversely opting for higher yielding, lower rated issues, which historically have been seen to recover initial losses following interest rate hikes. 

This article was issued by Mathieu Ganado, Junior 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.  

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