26th October 2010
The debate over a ‘bond bubble' has been raging for sometime, with Mindful Money having recently looked at the concerns being raised. Earlier this month Gartmore's head of credit John Anderson warned in an FT Adviser article that government bonds are caught in a bubble and investors should tread warily.
Jenna Barnard, director of retail, fixed income at Henderson Global Investors, says that while concerns over a bond bubble are palpable, they do relate mainly to government-issued debt. There are still plenty of investment opportunities to be found in other areas of the fixed income market, she insists.
Having said that Barnard confesses sympathy with those expressing the view that better long-term value is currently to be found in equities than in gilts or investment grade.
She says: "Valuations within certain areas have grown expensive, yes, and investment grade bonds – which are priced off gilts – do not present investors with the ‘once in a lifetime' opportunity that they did at the tail end of 2008 and early 2009, when valuations were at depressed levels and default rates were factoring in the possibility of a second Great Depression."
But while gilts are expensive they are not, by Henderson's calculations, extremely overvalued, though Barnard concedes we may be at the end of a long bull market for government-issued assets and the beginnings of a more positive period for equities.
Barnard, who co-manages the Henderson Preference and Bond and Strategic Bond Funds and the Henderson Managed Distribution fund, believes the most likely "tipping point" would be a second round of quantitative easing or "QE2'. Markets are also beginning to price in QE2 for the UK sometime in 2011.
Should QE2 take off, as seems likely, certainly in the US, Barnard feels investors will have to be very mindful of rising inflation: "The outlook is uncertain, but fortunately, as strategic bond fund managers, we are in the position to be able to direct our attention towards those areas of the fixed income markets where long-term opportunities persist."
Henderson says the biggest surprise for her this year so far has been the convergence of the three main fixed income asset classes, particularly the strong rally in the gilts market. "We have been cautious on the outlook for gilts for well over a year now and although with hindsight one could argue we were too early with this view, we believe that whatever value there was within the gilt-sensitive areas of the fixed income market, it has now been exhausted."
To accommodate the changed circumstances, Henderson, over the year, has gradually rotated its portfolios away from those bonds with high interest rate sensitivity – for example high quality investment grade names such as Vodafone and Imperial Tobacco – and moved towards lower duration bonds with less sensitivity to interest rate changes but with higher perceived default risk, such as financials and high yield industrials.
Another major factor colouring the outlook for bonds is re-regulation, both for banks and insurers, in the forms of Basel III and Solvency II, respectively. Earlier this week, as the Wall Street Journal reports, Bank of England Governor Mervyn King said Basel III, which calls for new, tougher bank capital and liquidity requirements, was a positive development although he believes it is vital further precautions are undertaken to prevent another serious financial crisis developing.
Henderson, for its part, views the Basel III proposals, published in September, as "extremely positive", as they are expected to bring significant changes to how financial institutions issue debt going forward and also for holders of existing debt instruments.
In this respect, Barnard cites as an example old-style "hybrid" banking bonds, which have both equity and bond characteristics. These are in the process of being phased out, leading to significant rallies in the value of several issues previously trading below par. Barnard expects these hybrids will make way for bonds with greater loss-absorbing characteristics that can rebuild capital and be more easily turned into equity.
One asset type likely to prove increasingly popular in this respect is contingent capital (or Cocos). Once issued, the equity characteristics of the bonds can be triggered should the issuer be in breach of requirements, such as its core tier 1 ratio. At this point, the interest payments of the bond are switched off and the asset itself converts into equity, or is written down.
"It is a clever solution for the banks in terms of offering a backstop for emergency capital raising without the need for government intervention should we face another banking crisis." However, she believes a number of issues will need to be addressed before the use of Cocos becomes widespread, for example it is feared that the inclusion of high triggers could make them prohibitively expensive for large numbers of investors."
For Barnard, the other notable area of opportunity is the high yield bond market, which continues to offer considerable value as the spread over government bonds remains at historically elevated levels. She cites analysis by Moody's showing that the rolling global 12-month average default rate for this class was 2%, and is forecast to fall to 1.8% next summer.
Barnard however expects the true figure to end up considerably closer to 1% once the defaults that took place during 2009 are factored out of the equation.
"With steady, albeit slow, economic growth and a benign corporate default rate environment, we think high yield can continue to perform well for the next six to twelve months," she says.