The financial market crisis has continued to put pressure on the riskier segments of the bond market...
The financial market crisis has continued to put pressure on the riskier segments of the bond market in recent months, including investment-grade and high-yield corporate bonds and emerging market debt. Despite aggressive rate reductions by the US Federal Reserve and monetary easing by the Bank of England, credit conditions have remained strained around the globe as banks remain reluctant to lend to each other.
The Fed was forced to broker an emergency rescue of Bear Stearns by JPMorgan Chase, exacerbating the breakdown of trust. Margin calls on a number of leveraged hedge funds prompted fire sales of assets at below-market prices, putting further pressure on global non-government bond markets. The major central banks have continued to inject additional liquidity into financial markets to maintain the stability of the banking system.
Additional Fed lending facilities and market intervention by a number of US housing agencies have provided some relief to non-government bonds since late March.
Despite weaker data, we retain our out-of-consensus view that the US economy will most likely narrowly avoid an outright recession or, if not, only fall into a shallow recession. Indeed, we expect US growth to rebound during the second half of 2008, following a weak first half.
However, with the economic outlook remaining on the downside, government bonds provide an attractive hedge against a deeper economic slowdown and continued volatility in higher-risk bonds.
We see significant opportunities in the non-government bond sectors at current valuations, as the difference in yields over government bonds has widened sharply. We believe valuations are currently affected by short-term market flaws, such as technical selling pressures and the breakdown in market-making by primary dealers, rather than reflecting long-term fundamentals.
Current spread levels are consistent with expectations of a severe recession in the US and a sharp rise in defaults to levels exceeding those seen at any time during the post-war era. We continue to view these outcomes as unlikely, and see particular value in select mortgage-backed securities and lower-quality corporate debt.
- Corporate bonds and emerging market debt have struggled in recent months
- Current spread levels are too pessimistic about the economic outlook
- Non-government bonds provide significant opportunities over a longer horizon
- Mike Zelouf, product specialist for the Western Asset Management Global Multi Strategy fund (offered by Legg Mason).
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