Good opportunities for high yield bonds if central banks manage an orderly transition

2nd January 2014

Bond fund managers are reasonably optimistic about the prospects for credit in 2014. Ariel Bezalel, manager of the Jupiter Strategic bond fund, says that the optimistic case is that the economic data broadly meets expectations and the market factors in an orderly process in terms of unwinding quantitative easing and future interest rate policy.

He says that under this scenario, there is a potential for high yield bonds to produce decent returns.

However Bezalel says he remains mindful that the US Federal Reserve faces a formidable task.

He says: “There is a risk that economic data will come in a lot stronger than expected. This may lead to a market panic over the pace of rate rises and potentially bring forward expectations for a rate increase to later in the year, igniting a 1994-style market reversal. This seems unlikely for now, as low US inflation is currently giving the central bank cause for concern and a justification for maintaining a gradual approach to tapering.

“In his speech, Ben Bernanke even highlighted that the Fed may consider further action if inflation did not move up towards its 2% target. However, should growth start to accelerate, US inflation data will receive close scrutiny and is likely to be a particularly important indicator for shaping bond market sentiment in the coming year”.

In terms of the UK, the fund manager notes that the Bank of England recently responded to a pickup in UK economic growth by bringing forward expectations for when unemployment would fall to its 7% target to December 2014, some 18 months earlier than previously indicated.

He says: “While this was largely expected by the market, a further acceleration of growth in the UK economy at a time when the Fed is withdrawing stimulus may cause headaches for Mark Carney and push UK government bond yields higher”.

In terms of Europe, he says there is mounting evidence that the economy is bottoming out. “We are now in a situation where growth is not great anywhere, but growth is everywhere. Although mindful of the difficulties the European Central Bank (ECB) faces in addressing the economic divide between Germany and the region’s weaker economies, we are encouraged by efforts (such as the bank asset quality review) to boost confidence and ultimately promote credit growth in the peripheral economies. We also believe the ECB may be forced towards more unorthodox policies should the shift in the Fed’s stance force interest rates higher in the region”.

Bezalel holds the view that European high yield bonds present some of the most compelling opportunities available for investors in fixed income. He says: “The region is enjoying low default rates, companies continue to focus on repairing balance sheets, the economic backdrop is stabilising and interest rates are likely to remain low for a prolonged period. These conditions contrast with those in the US where companies are more confident and therefore more willing to take on debt.”

In terms of sectors to spot, banks are in the midst of a multi-year deleveraging process which could see them revert back to utility-style businesses in the world of fixed income. This is providing opportunities for bond investors, he says.

He says other areas of interest include oil rig financing, debt recovery businesses and pub securitisation. he is also seeing new opportunities in Greece, Spain and Ireland for investment in corporate and sovereign bonds.

“While these opportunities are certainly cause for optimism, it is important not to be complacent. We are taking particular care to manage risks associated with changing interest rate expectations. At around 2 years, the Fund’s duration (sensitivity to interest rates) is relatively low. In the event that economic data in the US (and elsewhere) surprises significantly to the upside, we may look to take further measures  to seek to defend the Fund, although this cannot be guaranteed,” he says.

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