What will be the effect of tapering on global bond markets and what scenario will unfold for investors? Will the dollar strengthen in 2014? Can the debt crisis in Europe be considered in its final stages or is the solution still far away? Experts from Natixis Global Asset Management on global bond investing, interest rates for the Eurozone, US municipal bonds and European credit markets share their views on these important topics.
"The various experts of our group underline that there are still various factors that can trigger volatility on the markets" - underlines Antonio Bottillo, Managing Director for Italy of Natixis Global AM. “Today more than ever, the bond component of portfolios must therefore be managed from a different point of view in order to face the changed market conditions. This consideration is even more true for Italian investors, who have always been interested in the fixed income market and often with a significant bond component in their portfolio. Careful selection, flexibility in managing different market conditions, diversification between sources of return that can also consider market segments such as high-yield, convertible bonds, structured credit, are just some of the capabilities offered by our managers, all focused on building portfolios stronger and more durable".
Elaine Stokes, Fixed-Income Manager Loomis, Sayles & Company Given the now more stable global economic backdrop and slightly stronger growth in the US, Stokes is not surprised that the Fed will begin to reduce monthly bond purchases in course of the month of January. Last December 18, the Fed leaders decided to reduce monthly asset purchases from 85 to 75 billion dollars in the face of better prospects for the US economy. With that in mind, Stokes believes the positives for bond markets in 2014 will be investors' ability to identify stable and improving stocks, including corporate bonds, bonds issued by government agencies and municipal bonds subject to taxes.
“The presence of low and potentially rising yields is not the best scenario for bond investors. But if you are able to identify companies with positive growth potential due to your liability structure or the fact that the business outlook is improving and the company may be upgradeable, it may be possible to obtain a spread compression, coupled with satisfying earnings,” Stokes says. The best bond investment opportunities are currently found in the high-yield segment in its various forms. Stokes sees a significant yield advantage in “traditional” high-yield credit versus other fixed-income sectors, although yields have historically been low for bonds of this type. Other high-yield sectors, such as bank loans and convertible bonds, also currently offer attractive yields and are able to grow as interest rates rise. “As rates rise, the floating rate nature of bank loans is a positive. And as rates rise, convertible bonds' sensitivity to equities allows them to gain. So it's a question of looking deeply into the high-yield space and choosing the right position within the capital structure to achieve gains,” says Stokes. In 2014, Stokes will keep an eye on various long-term secular growth trends in particular industries, such as healthcare and technology.
“For example, in the healthcare sector, demographic trends are very important. The value driver of many companies in this sector is an aging population and the need to reduce costs, as well as the need for preventive assistance,” Stokes says. Among the challenges facing bond markets in the new year, Stokes points to a lack of liquidity that could cause significant price swings. “We expect this lack of liquidity to translate into persistent volatility over the next few years. When it becomes more and more challenging to trade bonds in the market and the different types of securities traded are increasingly interconnected, it becomes very difficult to get results,” says Stokes. Stokes adds that he has seen dramatic changes in the market over the past 10 years.
“Today it's about finding new ways to relate supply and demand. And so far we have not identified a primary trading mechanism. So in the meantime, what matters is the ability to find opportunities, and this will continue to drive volatility. If we then add the considerable uncertainty about the effects of the Fed's exit strategy in terms of quantitative easing, we expect this volatility to remain at least throughout 2014” states Stokes. Olivier de Larouzière, Managing Director of Euro Interest Rates Natixis Asset Management De Larouzière does not currently see any dominant global trend in sovereign interest rates for 2014. He expects limited rises or falls, mainly due to monetary policy accommodative, modest growth and no inflation. He believes that the ECB's Forward Guidance implemented last summer will continue to positively influence European bond markets. “The ECB is keen to give more visibility to its monetary policy for market participants. It wants to contain volatility, which is very useful for long-term investors looking for yields and, at the same time, it wants to help reduce perceptions of risk,” says de Larouzière. One difficulty that the euro area could continue to face in the first months of 2014 concerns the level of the euro.
“The euro has been a hot topic in recent years. It is known that the strength of the single currency represents an obstacle to the growth of the area and this will have to change at some point” says de Larouzière. He believes that market complacency is another hurdle to overcome in Europe. "Finance ministers have sent the message to markets that they need more time to consolidate balance sheets, even as growth is picking up." In what terms will the phase of expansionary monetary policy end? De Larouzière believes exiting the stimulus plans will be a purely US issue in 2014 but probably not for the eurozone before 2015.
“In the United States, we expect the process to be very gradual. The Fed is clearly concerned about the impact of any change in terms of monetary policy. Yields surged in the summer, with consequences for the real estate market. The Fed is aware of this effect, and will clearly wait for substantial improvements in economic indicators before making any policy changes,” de Larouzière said. Interest rate forecasts In a scenario of modest growth, absence of inflation, and expansionary monetary policy for the whole year, de Larouzière does not expect a rise in interest rates in the short to medium term during 2014. Interest rates at long-term they could rise to a range of 50 basis points from their current level, especially in the euro area, if the ECB adopts further stimulus measures including another long-term refinancing operation (LTRO). “We expect further measures to be taken at the end of the first or second quarter. And then, finally, towards the end of the year, we hope there will be more positive economic growth and inflation data. In that case, we could expect future changes in terms of monetary policy,” argues de Larouzière. As regards the issue of sovereign debt, de Larouzière believes that the most attractive yields and levels of liquidity can be found in “high-yield” countries, such as Spain and Italy.
He believes liquidity will continue to be a challenge in 2014 and that the US dollar offers further opportunities. "The Fed's tapering anticipations will lead to a strengthening of the dollar against other currencies," says de Larouzière. Philippe Berthelot, Head of Credit Natixis Asset Management According to Berthelot, given the context of modest growth and low interest rates, default rates on the European credit market in 2014 will remain very low. “European growth will remain rather contained, with the possible exception of Germany. We do not currently see any risk of inflation, on the contrary, there could be some risk of deflation. We do not believe an increase in interest rates in the medium term is possible, as central bank policies will remain accommodative, at least until mid-2014. In these conditions, the context appears rather favorable for bond investors” Berthelot argues. Judging by the default rates, currently below 3%, Berthelot finds the European high-yield bond segment particularly attractive, as well as asset-backed securities and convertible bonds. One of the key themes for 2014 will be, according to the analyst, the financing of SMEs (small and medium enterprises).
“Following the directives introduced by BASEL III, banks have less and less room for maneuver for corporate financing. Therefore the sector is looking for innovative solutions to finance those SMEs through loans or private placements. Another key element is the return of CLOs (collateralized loan obligations) in Europe. Can the debt crisis in Europe be considered over? Berthelot believes that unfortunately the end of the crisis is still far away. Despite the fact that much has been achieved in recent years, some countries such as Portugal continue to find themselves in difficulty. “Portugal must obtain a refinancing by June 2014. Furthermore, France and Italy must implement structural reforms for the labor market and the retirement system” says Berthelot. James Grabovac, Municipal Bond Manager McDonnell Investment Management Grabovac believes the outlook for the US municipal bond market will remain relatively good for 2014.
“Interest rates are higher than last year, which creates attractive investment opportunities, also because we do not believe that a substantial increase in interest rates in the short term is possible,” says Grabovac. The reason it does not expect significant interest rate hikes in 2014 is that, in the past, long-term interest rates have proven to be more closely related to inflation. Currently, inflation levels in the United States are very low, equal to approximately 1,5% as measured by the Consumer Price Index and 1,2% by the Consumer Spending index which the Fed pay close attention. Grabovac points out that municipal bonds have outperformed other sectors of the bond market in the past in rising rate environments due to the way municipal bonds are issued. “In a normal market environment, large refinancing issues are made as issuers take advantage of lower rates on the municipal bond market to refinance existing bonds previously issued at higher rates. But when rates rise, issuers have a harder time refinancing. In this sense, the municipal bond market tends to be autonomous to some extent: when rates rise, supply falls. But if interest rates spike, supply tends to increase slightly,” says Grabovac.
Areas of interest for 2014. Healthcare, higher education and transport are some of the sectors that Grabovac considers particularly interesting for the new year. Also, a behavioral trend that Grabovac has witnessed over the past year is investors' growing fear of rising interest rates, even as they desire higher yields. Because of this behavior, investors in the municipal bond market tend to favor bonds with maturities of less than 10 years, while avoiding those with maturities of more than 10 years. “This attitude has created many opportunities on the medium to long-term end of the yield curve for investors able to position themselves on these segments,” says Grabovac. In 2013 there were several significant episodes on the municipal bond market, which involved some issuers of primary importance: in July Detroit filed a request to access Chapter 9 for bankruptcy, in the third quarter the tax issues of Puerto Rico, which caused market swings. However, Grabovac finds it interesting that some of these high-profile issuers are going through a period of volatility while, at the same time, credit quality is improving in the market. “For 15 consecutive quarters, state and local revenues have increased. And, in general, moderate economic growth continues to support most municipal bond issuers,” Grabovac argues. Default rate levels for municipal bonds According to Grabovac, the default rate of municipal bonds represents a very different statistic than that of corporate bonds. For example, investment-grade municipal bonds have an average default rate of less than half a percentage point over a long period of time. Furthermore, the issuers who most often find themselves in difficulty and are unable to repay the securities are those involved in financing specific projects and real estate financing.
Risks Bonds involve credit, interest rate (as interest rates rise, bond prices usually fall), inflation and liquidity risks. The muni market can be volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of issuers of municipal securities. In addition, convertible bonds are subject to equity sensitivity and may have lower yields than other types of bonds. Bank loans are often lower quality debt securities and may carry greater risks of price changes and default on interest and principal payments. The floating rate bank loan market is largely unregulated and such assets are not usually traded on a structured exchange. As a result, floating rate bank loans can be relatively illiquid and difficult to value. Changes in exchange rates between the US dollar and foreign currencies may reduce the value of the fund's investments. High-yield securities may be subject to greater risks (including the risk of default) to a greater extent than other fixed income securities. An asset-backed security (ABS) is a security in which the payment of receipts and therefore their value is derived from and collateralized (or "backed") by a specified pool of underlying assets. A bank loan is a type of loan whose interest rate varies as market interest rates rise or fall.
BASEL III is a comprehensive set of reform measures aimed at improving regulation, supervision and risk management in the banking sector. Basis points are used to measure the change in a security or interest rate. A basis point is equal to 1/100 of 1%. Collateralized loan obligations (CLOs) are a type of securitization in which payments deriving from a plurality of medium and large commercial loans are pooled and transmitted to different classes of owners in various tranches. A convertible bond is a type of bond that can be converted into a predetermined number of common shares of a company. The European Central Bank's long-term refinancing operation (LTRO) is a process by which the ECB provides financing to banks in the euro area. A market maker is a broker-dealer who accepts the risk of holding a certain number of shares of a particular security in order to facilitate the trading of that security. Monetary policy refers to the cyclical pattern of increasing and decreasing the money supply through the adjustment of interest rates or the use of other economic stimuli. Muni-bonds are issued by a municipality, state or county to finance its capital outlays. Muni-bond income is exempt from federal taxes and most state and local taxes. SME financing is the financing of small and medium-sized enterprises, and represents one of the main functions of the general market of business finance, in which capital is offered, acquired, quantified or priced for different types of companies. Capital is provided through the business finance market in the form of bank loans and overdrafts. Tapering refers to the reduction of the US government's Quantitative Easing (QE) program implemented since December 2008. QE involves the purchase of Treasury bills and mortgage-backed securities by the central bank in order to keep interest rates low 'interest. The yield curve is the graphical representation of the relationship between bond yields up to their maturity.
