Anyone who has been involved in the fixed income marketplace in the past few years will be more than...
Anyone who has been involved in the fixed income marketplace in the past few years will be more than familiar with the arguments that the future for bonds lies in taking credit risk, rather than interest rate risk. These arguments are based both on the higher yields available from taking credit risk and on the growing size and liquidity of non-government bond markets, particularly in the UK and Europe.
It is ironic, then, that since the market in non-government bonds really has started to grow, the performance of the non-government bond sector has looked pretty lacklustre, even by the mediocre standards of recent government bond market returns.
Government bonds have gained a scarcity value versus corporate bonds, widening the yield spread between the two. There is no reason to think that the trends behind this dynamic will reverse any time soon.
Fundamental credit considerations have also worked to widen the yield spread. This spread can usefully be decomposed into two parts: the spread between the government bond yield and the swap rate and the spread between the swap rate and non-government bond yields.
Over the past couple of years, swap spreads have widened as government yield curves have flattened. With central banks apparently in control of inflation and willing to raise official rates on the slightest sign of rising inflation pressures, government yields are likely to remain low, and yield curves are likely to stay quite flat; in which case there is little reason to expect swap spreads to narrow significantly from their current historically wide levels.
Concerning individual credit spreads: corporations as a group have been gearing up their balance sheets in order to improve returns on equity. Thus, the credit quality of the average corporate borrower has been worsening. So, with the dynamics that have resulted in the uninspiring performance of the credit sector seemingly unlikely to change soon, should investors be buying credit now? Curiously, recent experience argues that, yes, they should: because, although the credit sector in aggregate has performed relatively poorly, some sectors and some individual corporate bonds, even in this period, have performed rather well.
In the high yield corporate bond market, if you had done no more than manage to avoid the five worst performing bonds each month, you would have already beaten the Merrill Lynch European currency high yield bond index by 3.1% so far this year.
The lesson of the market's recent performance, is that even during a poor environment for credit as an asset class, picking the right securities makes a very significant contribution to performance.
Laurence Mutkin is head of fixed interest strategy at Scudder Threadneedle Investments
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