Throughout 2002 bond investors preferred the relative safety of government bonds, but as signs emerge that investor confidence in stock markets may be returning we could see a reversal of this trend
Last year was a challenging one for corporate bond investors. Having survived an onslaught of credit rating downgrades, corporate defaults and contagion from massively volatile equity markets, 2002 probably passed with some relief.
Throughout 2002 bond investors preferred the relative safety and greater assurance of government bonds, but as signs emerge that investor confidence in stock markets may be returning, should we expect a reversal of this trend? This article takes a look at what's in store this year for global fixed interest markets.
The threat of global deflation will remain a strong driver for bonds, as will global monetary and fiscal policy, together with geopolitical risks. Most global central bankers are focused on stimulating growth in their economies and preventing deflation from taking hold. Deflation is already present in some areas of traded goods and services, but it has been there for a number of years and we believe it is unlikely to become a general phenomenon across the wider market.
Local factors such as competitive pressures, politics and the corporate sector, are driving the deflationary forces in the countries where deflation is entrenched. Appropriate policy responses in other parts of the world should ensure that modest inflation does not turn into deflation. The greatest risk of deflation is in the eurozone where the ability to take reflationary measures is constrained by a more rigid policymaking apparatus.
The prevailing global interest rate environment is aggressively pro-growth, with both US and European central banks taking action to stimulate activity. In the US, Federal Reserve policymakers attempted to address stuttering economic progress by lowering the benchmark interest rate by 0.5% to 1.25% in November.
In Europe, the ECB followed America's lead, delivering the 0.5% cut that investors were hoping for. This took interest rates there down to 2.75%, the lowest level in more than three years. Importantly though, central bankers, particularly in the US, have been at pains to point out that they have a number of other tools in their armoury besides interest rates.
Given this concerted approach to trying to reflate economies, bond investors have started to give less weight to the likelihood of deflation and have turned their thoughts to inflation, albeit further down the line. As a result, we have seen yields of longer dated high quality government debt edge higher in recent months.
Certainly, we are more likely to see a period of low inflation rather than deflation, and deflationary concerns are still, in our opinion, overdone. With risks to short rates still being skewed lower, we expect to see the yield curve steepen as bond investors worry more about the impact and efficacy of reflationary policy measures.
Expansionary fiscal policy will also have an impact on bond markets this year. In the US, the Republicans' strong showing in the November 2002 mid-term elections makes the timely implementation of additional fiscal stimulus likely, while changes to President Bush's administration seem to be an attempt to clear the decks for a series of pro-growth policy announcements.
Interestingly, Federal Reserve chairman, Alan Greenspan, has cautioned against using big changes in taxes and public spending to manage the economy, saying their effects are uncertain and could threaten long term fiscal stability. In the UK, with economic growth forecasts lower and the need for continued spending on health and education, the Chancellor's pre- Budget report radically revised the government's spending requirements by £20bn, but even this looks conservative.
Despite the Federal Reserves' 50 basis point insurance policy against another slump in demand, US Treasuries have drifted higher. Traded insurance products outperformed in 2002 and given the current strong reflationary stance of the US authorities, we expect them to have another good year.
Meanwhile, in the UK, following Gordon Brown's pre-Budget announcement, the gilt market has begun to account for the additional supply to be raised in 2003, as well as the redemption of existing gilts. Worldwide, we expect government bond yields to come under increasing pressure as investors fret about expansionary fiscal and monetary policy. As for other government debt, the first supply of the new year has been taken up well, with JGB and Bund auctions all being comfortably covered.
In the corporate bond market, some of the same issues that affected it last year will remain influential, including working off the hangover left from the most pronounced bear market in the post-war era. Last year was a record year for downgrades to the credit ratings of corporate bonds and at no time in credit market history have so many companies dropped from investment to speculative grade.
According to Standard & Poor's figures, almost 70 companies across the world have fallen to junk status, with another 76 firms teetering on the brink. Despite better equity market performance in the last quarter of 2002, credit specific concerns have continued to drive the corporate bond market and we expect high profile credit-blow-ups to continue to test the nerves of investors.
However, there are signs that the credit environment is improving and that there are reasons to believe that the worst is behind us. Globally, the number of company's defaulting on their debt has been falling - for the year ending October 2002, the number of defaults was racked up at 120, compared to 212 in the whole of 2001. The companies that have defaulted have tended to be those within weak industries.
This has left only the healthiest corporate debt surviving. Even the default rate for speculative grade issues has been on a downward trend and Moody's predicts that it will have fallen down towards 6.7% by the third quarter of 2003, from 9.0% in October 2002. Balance sheets have been improving steadily as debt reduction has taken place, aided by better free cash flow in many instances.
What should we expect in terms of issuance of corporate bonds? The supply that had been choked off at various points during 2002 may re-emerge in 2003 and could lead to a period of indigestion. This may result in pressure on relatively expensive government bonds being switched into corporates, as investors reach for yield.
In the eurozone, access to the market proved challenging in 2002 for some lower rated issuers and the delay or cancellation of planned bond sales dominated. We can expect this overhang to come through in 2003. In the US meanwhile, corporate supply has been strong in the first few days of the new year, with $60bn of issuance being clocked up in the first week or so. Against this increased supply, demand for corporate paper has remained strong, given the economic and financial backdrop.
Given the prevailing reflationary policy environment, our preference is for corporate bonds over government issues. As the corporate sector puts some of its traumas behind it, confidence is slowly returning and spreads have tightened. If and when equity markets do break convincingly higher, capital flows out of bonds and into equities will be most damaging to government bonds. Credit-specific issues will remain a focus for corporates but spreads should continue to narrow as the number of downgrades subsides and investors believe we are over the worst. An environment of steepening yield curves will be helpful towards further spread contraction.
The outlook for bonds is clouded by the aggressive reflationary policies of authorities around the world, which have the potential to raise inflationary expectations. Bonds will eventually suffer inexorably from the upturn in inflation expectations and the rise in government debt levels around the world.
But, for now, they are underpinned by steady demand from investors for yield, and as long as equity markets fail to convincingly break higher, bonds will retain a bid. However, uncertainties in the geopolitical environment will ensure that fixed interest prices remain volatile.
Threat of deflation strong driver for bonds.
Government bond yields expected to come under pressure.
Number of companies defaulting has been falling.
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