Fragile recovery and static rates
Unlike international football referees, longevity in the financial markets depends on a certain ability to admit when you might be wrong. More importantly one always has to have a contingency plan for whenyou are wrong, such as closing a losing position or readjusting one’s investment horizon .
At the moment, bonds aren’t doing what I expect them to do over the medium term – they are rallying and the two-year Treasury note hit a low in yield for the year on Thursday. In fact, yields have fallen in most markets over the last couple of weeks – just after it looked as though a bond bear market might have been starting. I have to admit that it does not look as though government bond yields are going to go up much in the near term.
A key reason why front-end bonds are rallying is that central banks continue to chant the “lower for longer” mantra. Last week a senior Fed official suggested that there would be no increase in the Fed funds rate until 2012. Our view is that rate hikes will come sooner than that but the point is that there has been no suggestion from the Fed, the ECB or the BoE that officials feel the need to start preparing the markets for a rate hike in the next 3-6 months. So, bond yields remain well anchored and investors appear to be taking some risk off the table as we approach the end of the year.
Unattractive government bonds
The result is a very unattractive yield level at the front end of government bond curves: 0.7% for US Treasuries, 1.27% for UK gilts and 1.23% for European government bonds. In my view, bond investors that are searching for higher yield will need to take on more risk by either taking on additional duration risk or by taking on additional credit (or in the case of Europe) sovereign risk. To me the best strategy remains to limit duration exposure and take on more short-dated credit risk. Going longer on government bond curves does not provide that much extra yield: 3.35% for US Treasuries, 3.67% for UK gilts and 3.27% for Euro governments. These yields are not very exciting and carry with them a significant risk of capital loss when yields eventually rise.
Treasury yields hit their lows last December and are up since then but still at levels consistent only with a sub-par economic recovery, below target inflation and zero-bounded official interest rates. The same goes for European and UK government bonds, though the lows persisted into the first quarter of the year. Long-term government bond yields are not at levels anywhere near a normalisation ofthe economic cycle. Of course, the cycle may not normalise. The recovery could be very anaemic because of high unemployment, continued private sector (household) balance sheet adjustments and a lack of credit. Despite the impressive recovery in global business surveys, turnover in the business sector remains well below previous levels. In the US total business sales have picked up by about 2% from the low they reached earlier in the year, but are still 13% lower than a year before.
I put a fairly upbeat spin on housing in my last note, but the reality is that at the moment the recovery is fragile – housing starts in the US were disappointingly weak in October and mortgage delinquencies rose to a level of 9.64% in the third quarter. However, I am still of the view that the downside risks to the global growth outlook are limited by the fact that a lot of adjustment has already occurred and by the fact that a significant amount of policy stimulus is in place. As such I would argue that a 1% rise in global government bond yields in the next year is more likely than a 1% fall.
Go short (maturity)
So for yield in fixed income, the short maturity credit looks the best bet still. Taking data from BoA/Merrill Lynch the yield on the broad market index of bonds in the 1-3 year maturity is currently1.974%, but around half of this index is gilts anyway. For the non-gilt index (corporate, collaterised and supranational issues) the yield is 2.79%. For corporates in this maturity bucket the yield is 4.3% (better than anything you can get in gilts). If one is really willing totake on credit risk, the BBB UK corporate bond 1-3 year maturity index gives a current yield of 6%. Of course, the risk with credit is clearly another round of economic weakness and increased default risk.
However, the encouraging thing about credit this year has been the record amount of corporate issuance and the fact that it has been well received by investors, so reducing the refinancing risk in the market. The other attraction of the short-end of the credit market is that it gives investors access to cash-generative businesses without taking on equity risk. Over the past ten years the correlation of equity returns with those from the one- to three- year part of the credit market has been just -0.08.
It is still a time for caution so my view on the bond market is to minimise duration risk, have some inflation protection and earn the carry from investment grade credit. We expect RPI to increase sharply in 2010 and continue to see some medium-term inflation risks, so the inflation uplift on index-linked bonds makes them a better bet than gilts or holding cash.
The UK government released the public sector finances for October. The net borrowing requirement was £11.4bn in October, taking the 2009/2010 fiscal year total to £86.9bn and the 12-month running total to£137.7bn. This is even worse than expected and, if current trends continue, the full year borrowing requirement will be more than the £175bn suggested by the budget.
