Jenna Barnard: the Keynesian animal spirit threat to bonds

For the last two years, due to the macro volatility, we have been wildly oscillating between recession, recovery and growth. The recent frenzy of corporate activity has pushed the market into the boom phase of the credit cycle – animal spirits are back.

Cheap debt has been available for some time but it requires the crucial ingredient of confidence to take advantage of this.

With this in mind it is worth noting that US private equity firms have been sitting on $200 billion of cash raised in 2007 and 2008 and over the next few years the majority will have to invest or return cash to investors before their investment period ends.

The difference in this cycle has been that whilst previously we saw a ramp up in deal size from $15 billion for Hertz in 2005 to $44 billion for TXU in 2007, and the associated leverage creep up, this time around we have 2006 and 2007-sized potential transactions announced in the form of Heinz and Dell already.

These transactions have large shareholders supporting the transaction and may not be representative of a typical buyout, but a new trend appears clear: merger and acquisition (M&A) activity should be expected to pick up in the coming year fuelled by cheap debt.

Where are the best returns?

At the start of the year, we, like many of our investors, were scratching our heads looking at fixed income wondering where we could seek out returns after the stellar performance of investment grade and high yield in 2012.

With a flexible mandate, the Henderson Strategic Bond fund can seek out areas of the market which are less sensitive to rising rates: floating rate loans for example, whilst hedging out interest rate risk with derivatives when necessary and focus on areas of the bond market which still offer value.

Indeed at this stage of the cycle, event risk, which is so negative for investment grade bond holders, can actually be positive for high yield bondholders where the companies are already leveraged and have better legal protections.

For example our holding in Kabel Deutschland bonds recently rose on speculation that investment grade Vodafone was interested in buying it.

Although the loans can be repaid at par at any time, the high yield bonds have price upside potential reflecting the premium Vodafone would have to pay to redeem these bonds. Clearly, selectivity is key at this point in the market cycle.