In 2014, global bond markets will pay close attention to the actions of the US Federal Reserve (Fed), which has started to wean the US (and global) economy off its $85 billion per month quantitative easing programme.
The news that the Fed would initially taper its programme by $10 billion per month was greeted well by bond and equity markets.
The lower-for-longer tone to the Fed’s projections for interest rates was also positive and underscored the fact that the Fed believes the economic recovery still has some way to go. The cautious tone also affirmed the central bank’s desire not to relinquish control of interest rates and cause undue weakness in the economy and markets.
Reasons for optimism and possible cause for concern
We remain optimistic about the outlook for credit markets in 2014. Our optimistic case is that economic data broadly meets expectations and the market factors in an orderly process.
Under this scenario, we believe there is potential for high yield bonds to produce decent returns.
However, we remain mindful that the Fed faces a formidable task. There is a risk that economic data will come in a lot stronger than expected. This may lead to a market panic over the pace of rate rises and potentially bring forward expectations for a rate increase to later in the year, igniting a 1994-style market reversal.
This seems unlikely for now, as low US inflation is currently giving the central bank cause for concern and a justification for maintaining a gradual approach to tapering.
In his speech, Ben Bernanke even highlighted that the Fed may consider further action if inflation did not move up towards its 2% target.
However, should growth start to accelerate, US inflation data will receive close scrutiny and is likely to be a particularly important indicator for shaping bond market sentiment in the coming year.
Closer to home, the Bank of England recently responded to a pickup in UK economic growth by bringing forward expectations for when unemployment would fall to its 7% target to December 2014, some 18 months earlier than previously indicated.
While this was largely expected by the market, a further acceleration of growth in the UK economy at a time when the Fed is withdrawing stimulus may cause headaches for Mark Carney and push UK government bond yields higher.
In Europe there is mounting evidence that the economy is bottoming out and we are now in a situation where growth is not great anywhere, but growth is everywhere.
Although mindful of the difficulties the European Central Bank (ECB) faces in addressing the economic divide between Germany and the region’s weaker economies, we are encouraged by efforts (such as the bank asset quality review) to boost confidence and ultimately promote credit growth in the peripheral economies. We also believe the ECB may be forced towards more unorthodox policies should the shift in the Fed’s stance force interest rates higher in the region.
The best opportunities
In terms of strategy, we continue to hold the view that European high yield bonds present some of the most compelling opportunities available for investors in fixed income.
The region is enjoying low default rates, companies continue to focus on repairing balance sheets, the economic backdrop is stabilising and interest rates are likely to remain low for a prolonged period. These conditions contrast with those in the US where companies are more confident and therefore more willing to take on debt.
In terms of specific sector opportunities, banks are in the midst of a multi-year deleveraging process which could see them revert back to utility-style businesses in the world of fixed income. This is providing opportunities for bond investors, in our view.
Other areas of interest include oil rig financing, debt recovery businesses and pub securitisation. We are also seeing new opportunities in Greece, Spain and Ireland for investment in corporate and sovereign bonds.
While these opportunities are certainly cause for optimism, it is important not to be complacent.
We are taking particular care to manage risks associated with changing interest rate expectations. At around 2 years, the fund’s duration (sensitivity to interest rates) is relatively low. In the event that economic data in the US (and elsewhere) surprises significantly to the upside, we may look to take further measures to seek to defend the fund, although this cannot be guaranteed.