By Chris Iggo, CIO, fixed income, AXA Investment Managers
There is nothing better than focusing a fund manager’s or an analyst’s mind than having a discussion with clients about the investment outlook. Nick Hayes and I spent two days in Scotland last week seeing wealth managers and financial advisors and discussing with them a range of subjects that are likely to be important to the bond market over the next year. Writing on St. Andrew’s Day, it must be said that on a cold bright November day, visiting clients in Glasgow and Edinburgh was a real treat.
The bond bubble
At almost every meeting the question was asked, “do you think we are in a bond bubble?” As Nick pointed out, you should only worry about a bubble if you think that when it bursts you will lose a lot of your capital. Think Tulips or dot-com or Irish house prices. In bonds, unless you own bonds that default, you should always get your money back. I would add that normally a bubble is based on overexuberant expectation of return. People expected technology stocks to keep on rising in 1999-2000 even if the companies could not demonstrate current – never mind prospective – earnings. If you invest in bonds, the most you should expect is to get 100 back when the bond matures. If you are lucky enough to buy the bond at a price below 100 then there is some capital gain along with the coupon income. But if you buy a bond at above 100, you will experience a capital loss and the total return is determined by the coupon and the purchase price. There should be no surprises in terms of the mechanics of the return of bonds if you intend to hold them until they mature. If people have exuberant expectations of bond returns, they are in the wrong asset class. It is true returns this year have been extraordinary In 2012 underlying bond yields fell as central banks engaged in QE or promised to keep rates on hold for a very long time, and credit spreads narrowed. In the corporate bond market the technical factors have been very strong, with limited net issuance and very strong demand coming from pension funds, insurance companies and individual investors seeking yield without the volatility of the equity market. Even though the macro-economic environment leaves a lot to be desired, growth in many places has not been so weak that corporate earnings have been badly damaged, nor has it been strong enough to make investors worry about rising interest rates. Credit has been the sweet spot. The lack of confidence in the economic outlook has fostered a climate of conservatism among corporate managers who have tended to hoard cash. This means the credit fundamentals have been strong. In the financial sector, banks have continued to de-leverage and the improved sovereign climate since the summer has weakened the perception that banks are just a play on the sovereign credit. With limited new issuance of subordinated or senior debt, bank paper has been attractive at yields that have been well above those available on investment grade corporate debt. In high yield, corporate fundamentals have also been good and the refinancing situation extremely favourable, such that there is little sign of default rates rising from historically low levels.
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