Bond market perspectives
As we head into April, we expect a continuation of the global economic recovery, low short-term interest rates, a steep government yield curve in the US, and improving fundamentals in the corporate sector. Market volatility will most likely be a constant presence going forward, as well.
Market consensus is that the US economy is going to grow at about 3.5% in 2011. Unfortunately, it may be that the markets are going to have to come to grips with the fact that 3.5% is not fast enough to close the high unemployment gap. That means interest rates are likely to stay low for a longer period of time.
We don’t see the Fed making a move until there are real signs of expansion. And in order to truly expand, growth rates probably need to be above 5.5%. That does not seem realistic in the current environment. Given this economic backdrop and a steep yield curve, there is a lot of incentive to take risk.
Recovery favours high yield
Higher yielding corporate bonds remain a favourite of ours, not because valuations are so compelling but because the yield advantage helps to insulate a portfolio over the long term. By all means it’s not a table-pounding time for high-yield bonds, but given the fundamentals, including very healthy corporate balance sheets, it is a good time for high yield.
Currently, we are focused primarily on higher yielding corporate bonds with credit quality ratings in the double and single Bs (BB to B). We are not comfortable taking risk with lower-rated CCC bonds. Normally in an economic recovery we would take lower quality risk. But the transition of going from recovery to an actual expansion is not happening with the same timeliness as in past recoveries.
Therefore, if we are going to continue on this very modest path to recovery, low growth rates can be challenging for lower-rated securities. As a result, we believe it is more advantageous to take risk in equity-sensitive securities such as convertibles.
Areas where we continue to identify value opportunities are in cyclical credits, such as paper, chemicals, steel, and even autos to some extent.
Commodity currencies remain attractive
The commodity currencies of Australia, New Zealand and Canada continue to look attractive to our Multisector Team. The benefit in the short term is the deep liquidity that is provided by these markets. In the long term, we see significant upside in the secular trend for natural resources as greater demand pushes up those currencies.
In the long term, inflation is definitely a concern for fixed-income investors. However, with the overriding issue in the developed world now being to get the economy growing, inflation is less of a concern in the near future. In fact, corporations that our analysts are talking to report they have very little pricing power. So we don’t see inflation as a near-term risk.
However, we do think about it as we are positioning portfolios for that eventual time of rising rates. In that respect, we are focused on currency as a potential inflation hedge. We are avoiding market risk and moving away from interest-rate-sensitive US Treasuries. Also, we look to shorten the duration. But again, we believe low interest rates will be around for a little while so we can be patient and take that duration down slowly.
2011 will be a transitioning period for fixed-income markets. In this uncertain landscape, we believe careful investment selection in high-yield credit, convertibles, emerging market debt and non-dollar bonds will offer long-term value.