It is hardly an exaggeration to state that the new millennium starts on a subdued note for bonds. In...
It is hardly an exaggeration to state that the new millennium starts on a subdued note for bonds. In contrast, 12 months ago sentiment was generally positive, reflecting the impact of an outstanding year during which Western government stocks acquired safe haven status, with gilt yields tumbling to levels last seen in the 1950s.
That backward-looking consensus has, with a few exceptions, failed to serve investors well in 1999. Now the pendulum has swung to the other extreme. With 2000 set to be a strong year for global growth and central banks likely to respond by increasing interest rates, bonds command little support. Whilst that general view could prevail initially, it may prove over-cautious on a one-year view. It also disguises the potential available in specialist areas, like high yield and emerging markets.
Markets dislike uncertainty and during such phases they inevitably err on the side of pessimism. Currently, this takes the form of pricing in significant monetary tightening while giving little credit to positive developments. Valuations are already reflecting this view, with inflation-adjusted yields on government stocks on US and German 10 year benchmarks standing at over 4%.
Surprisingly, bond investors appear to be taking little note of the implications of increasing globalisation and of e-commerce on headline inflation rates. This combination could develop into a powerful theme in the coming year, prompting a more favourable review of interest rate assumptions. If it becomes apparent that the peak of the current interest rate cycle may be in sight and at only moderately higher levels than at present, investor sentiment would shift significantly.
Familiarity with corporate and sovereign country high yield bond markets and their potential in a relatively low interest rate environment is likely to increase this year, especially among the growing constituency of income-seeking savers. Investors have tended to take a very cautious view of credit risk, with the consequence that yield spreads over government stocks remain wide (around 110 basis points for AA-rated sterling corporate bonds and well above this for sub-investment grades).
A more positive global macro-economic picture should lead to a more helpful operating environment for corporate issuers. This should be reflected in improved credit ratings. There is already evidence that this is happening in certain high yield markets, notably the US. The point can be made even more forcefully for emerging market debt, where spreads have started to move in significantly, despite recent defaults in Ecuador and Pakistan
Emerging market debt produced an average 15% return during 1999, albeit from an extremely depressed level at the start of the year. Such a turnaround against a mixed background gives a likely clue to what may happen in other high yield debt markets. We expect good returns in 2000 from many of these high yielding bonds, although we continue to stress the need for careful stock selection and thorough analysis of credit and market risk.
Developments on the foreign exchange markets will continue to play an important role for UK-based bond investors. We believe the great opportunity for 2000 is likely to be the recovery of the euro, which has lost over 13% of its value against sterling over the past 12 months. The single currency has proved very beneficial to the growth of European debt markets; this process is still at an early stage. The size of the European corporate debt market is set to grow significantly, while investors should also benefit from positive returns from government stocks of countries like Poland and Hungary (which wish to join the EU) and from aspirants to EMU membership (like Greece).
John Hatherly is head of research at M&G Group
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