The rally in US corporate bonds has been impressive during the first half of the year but the big qu...
The rally in US corporate bonds has been impressive during the first half of the year but the big question for investors is how much further it has to run.
Lehman Brothers credit analyst Mark Howard says neither the war in Iraq nor the stagnant US economy prevented the credit market from posting its largest-ever first-half tightening, with the spread between Treasuries and corporate debt contracting some 55 basis points over the six months to 30 June.
Howard believes this move was even more impressive as it was preceded by a tightening of equal magnitude over the last two months of 2002. The largest push came from demand-side technicals, as investment-grade credit was seen as offering significant risk/reward benefits compared to other investment-grade bond classes, he notes.
'With such an impressive performance to date, the question is whether the market still has legs,' Howard says. 'Our answer is yes but the potential outperformance in credit is far less than at the beginning of the year.
'While the technical trade that propelled credit down in 2002 and up again in 2003 is running on fumes, this catalyst is being replaced by a combination of curve and fundamental considerations that will allow investment-grade credit to consolidate its gains and absorb a seasonal bout of risk aversion before tightening in the fourth quarter of 2003.'
Unless the market is caught out by an external shock such as terrorism, Howard adds the short-term boost created by US policy stimulus and improvements in corporate credit quality will stand corporate bonds in good stead for the immediate future.
'The ultimate price to be paid by risky assets for this stimulus and its related excesses is most likely a 2004 phenomenon that will compound other election-year turbulence and make next year more challenging for credit investors than 2003,' he warns.
Accordingly, Howard believes individual stock selection is critical but he points to a number of sectors that should provide richer rewards. Autos, insurance, telecoms and media, electrics and banks are likely to be key to performance through to the end of the year, he says.
Ron Tabbouche, co-manager of GAM's Star USD Bond fund, agrees the upward momentum in bond prices is likely to remain as interest rates are expected to fall further and there is ample excess capacity in the US economy.
'However, we should not become complacent as there is likely to be a high degree of volatility, particularly in the long term,' he says.
Tabbouche believes the US Federal Reserve has set itself the difficult task of simultaneously raising long-term inflation expectations while keeping long-dated bond yields low to foster economic growth. Technical factors can also defy the fundamentals of the market, he warns, particularly when the market is overbought, as is the case at present.
'As has been seen over the past few quarters, bonds have, on occasion, collapsed on the basis of no change in the economic picture,' he says.
So even those who believe bonds should perform reasonably well are suggesting any buy-and-hold strategy will need to endure plenty of volatility.
Strong rise in bonds over first half.
Credit quality improving.
Strong demand for corporate bonds.
Past outperformance may not continue.
Turbulence expected in 2004 from US election.
Conflicting task for US Fed.
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