Another year over – 2012 returns in fixed income markets

It’s been another massive year for the global economy. Europe saw LTROs, Greece got a haircut, sovereign downgrades and record high unemployment rates. The peripheral European nations attempted to implement austerity measures with limited success. The US re-elected President Obama and the focus quickly shifted to the upcoming fiscal cliff. In the UK, an Olympics induced bounce in growth was the sole bright spark for an economy which appears to be stuck in quick sand and may well lose its prized AAA rating in 2013.

The IMF, being unusually succinct, probably summed up the state of the global economy the best by entitling their latest World Economic Outlook “Coping with High Debt and Sluggish Growth”. The advanced economies account for around two-thirds of global GDP and if they are sluggish then global growth will be sluggish too.

With all this uncertainty and risk in 2012, how have fixed income markets performed? Surely government bonds will be the safe haven of choice?

In absolute and local currency terms, it’s been another great year for the markets with everything generating a positive return except UK linkers. It’s been a fall in grace for UK linkers, which were actually one of the best returning asset classes of 2011. The UK linker market was buffeted in 2012 by weak growth expectations and uncertainty surrounding proposed changes to the RPI calculation.

But looking elsewhere, investors had the opportunity to secure some excellent returns in 2012 by taking some risk. The best performing asset class of our sample was European subordinated financial debt which registered a return of 29.5%. European high yield wasn’t far behind with a return of 27.1%, followed by Sterling banks which returned 23.0%.

ECB President Mario Draghi and the ECB’s measures to support the Eurozone also had a positive effect of debt investors in peripheral Eurozone debt, with an index made up of bonds from Greece, Ireland, Italy, Portugal and Spain government bonds up 18.7%. Not a bad return for investors considering the question marks hanging over the ability of these nations to service their respective debt obligations in an environment of political uncertainty and recessionary levels of growth.

Other highlights include global high yield (up 18.7%), European peripheral financials (up 17.0%) and US high yield (up 15.6%). At the less risky end of the spectrum, European investment grade corporates returned 12.8% and US investment grade corporates returned 10.2%. Emerging market debt also did well, with EM sovereigns debt posting a fantastic return of 21.4%.

The dash for trash – YTD total returns in fixed income

As outlined earlier, it appears that the global economy faces some substantial fundamental headwinds. So how was it that the riskiest asset classes in fixed income have performed the best? Three little words – “whatever it takes”. Mario Draghi’s speech in late July supercharged returns for the riskiest asset classes and stimulated the “dash for trash”. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

Well Mr Draghi, the markets have certainly believed you. For example, an index of government debt issued by Greece, Ireland, Italy, Spain and Portugal had up until the speech date generated a return of around 5%. The index ended up generating a 17% return, with investors comforted by Mr Draghi’s comments.

Super Mario to the rescue

It seems to us that the Ostrich effect (the avoidance of apparently risky financial situations by pretending they do not exist) had a significant impact on markets in 2012. And in a world of ultra-low interest rates and negative real returns in cash, investors must take on risk. It is precisely what central banks are encouraging us to do. But uncertainty breeds volatility and in order to generate higher returns investors must face this volatility head on. It will be a feature of the market in 2013.

About the only thing we can say for certain is that it is unlikely that fixed income will continue to generate excellent returns across the spectrum from government bonds to high yield. For example, double-digit returns in European investment grade are not normal and has occurred only three times in the last seventeen years. On the other hand, the asset class has posted a negative return in only two of those seventeen years, with the largest loss being -3.3% in 2008. In US high yield, the consensus amongst analysts is that high yield markets will generate a return of around 4-6%, the result of coupon clipping. Analysing returns for the asset class shows that a coupon-clipping year has occurred only once in the past twenty-five years.

We posted our bond market outlook last week. It looks like the US may experience a housing induced growth spurt, Europe will eventually get round to dealing with its issues and the UK has a long way to go to secure economic growth. We like non-financial corporates, are worried about EM debt valuations and remain confident that there are still attractive investment opportunities in several areas of the fixed income universe. For an expansion of these views and more, please see here.


Baltic Dry Index indicating grim growth outlook and bond rally

The Baltic Dry Index, a measure of commodity shipping costs, is often used as an indicator of global demand, and it has a pretty good relationship with government bond markets too as we’ve discussed previously. The index has received much publicity over the past few years since it very accurately flagged the carnage of Q4 2008.  One of the index’s attractions is that unlike financial markets, it’s not subject to speculation (although of course shipping rates are influenced by their own set of demand and supply factors).

Today the index fell to 1495 points, which is the lowest since April 2009, and the trend is fairly firmly downwards.


Baltic Dry Index suggests weakness ahead for government bonds

The Baltic Dry Index is a measure of the price of shipping dry goods such as coal, iron ore or grain, and is commonly used as an indicator of global demand.  The beauty of this index is that unlike financial markets, it’s not subject to speculation. We’ve mentioned the Baltic Dry Index once before on this blog, when Jim highlighted at the beginning of September 2008 that continued new lows in the index were good news for government bonds (see here). 

Now, the index is beginning to suggest the opposite.   This chart (data as at today) illustrates the index level versus 10 year government bond yields in the US, Germany and the UK since the beginning of April 2009, and government bond yields haven’t followed the Baltic Dry Index higher in the past couple of weeks (at least they hadn’t when I started messing around with the chart on Thursday, although unfortunately for the purpose of this blog comment there was a pretty hefty sell off on Friday).

A rise in the Baltic Dry Index is all the more important because it tends to exhibit strong momentum.  For example, since the beginning of April, a daily increase has been followed by another daily increase (or a daily decrease followed by another decrease) more than 80% of the time.

Before people get too excited though, it’s worth remembering that shipping rates are influenced by their own set of demand and supply factors (eg the supply of ships) so the correlation can and does change over time. But given the Baltic Dry Index’s strong track record, it’s definitely something worth keeping a close eye on.

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US economy: hard landing or soft landing?

A stream of poor economic data and some horrendous writedowns from the big banks have meant that risky assets have been walloped. The iTraxx crossover has shot out from 340 to 470 since the start of the year, and most of the world’s equity markets are down between 10 and 15%.

The recent release that I’d like to focus on is last week’s Philly Fed number (or the Federal Reserve Bank of Philadelphia’s Business Outlook Survey, to give it its full name), which has been an excellent leading indicator of US growth going back 40 years. Prior to the announcement, market consensus had been for a reading of -1.0, a slight improvement on November’s -5.7. The market consensus got it very badly wrong though, and the Philly Fed number was actually -20.9, the weakest reading for six years. According to my chart (click to enlarge), a reading of -20.9 means a US growth rate of zero should follow.

Looking back over the 40 year history, the Philly Fed survey has only gone slightly wrong as a predictor on two occasions. The first was in Q2 1995, when confidence was dented by Mexico’s financial crisis, which coincided with the Federal Reserve hiking rates very aggressively (the Fed took rates from 3% to 6% from February 1994 to February 1995). The Federal Reserve averted a serious slowdown by cutting rates over the second half of 1995, and the US economy experienced a soft landing rather than a hard landing.

The only other wonky reading was in September 1998, which followed Russia’s default and the LTCM crisis. Although emerging market economies were in turmoil, the US economy was relatively unscathed, helped by the Fed cutting rates very rapidly from 5.5% in September 1998 to 4.75% in November 1998. Despite the financial mess at the time, though, the Philly Fed survey still only fell to -14.1, which is still quite a bit better than last week’s number.

The Fed has applied the usual dose of medicine to this crisis by cutting interest rates rapidly, but will it be enough to prevent a hard landing? I don’t think so. The financial crises of 1994-5 and 1998 came at a time when the US economy was already fairly strong, and it was able to withstand the shock. This financial crisis, however, has come at a time when growth was already weak, and the housing market was already falling. I think the Fed will continue cutting rates to avert recession, but I don’t think it will be enough.

Leveraged loan market shrugs aside global pick up in volatility

Over the past few weeks, equity markets have seen falls of around 6%, and while the high yield market correction hasn’t been as severe, the iTraxx index still widened from a spread of 179/180 on February 26th to a high of 235/238 on February 28th, before clawing back some of the losses. During these turbulent times, the secondary prices traded in the European leveraged loan market remained largely stable – "rock solid" and "business as usual" according to some commentators. How has the leveraged loan market managed to remain so stable in the face of growing risk aversion?
Much of this has to do with the way loans work. As secured floating rate instruments, they are largely uncorrelated with other mainstream financial assets, providing some insulation from instability in the equity and high yield bond markets.

That said, demand continues to be incredibly strong for the asset class at present, with a clear imbalance between supply and demand (Standard & Poor’s suggest there could be aggregated latent appetite of the order of €40bn stemming from European and US CLOs, other fund investors, prime funds and repayments). This imbalance is only likely to be exacerbated by jitters in other markets, with investors seeking what they might perceive to be a ‘safe haven’ in a period of uncertainty. These factors serve to reinforce some more negative features creeping into the market – including increasingly aggressive (leveraged) transactions, and most notably downward pressure on spreads that sponsors and arranging banks are prepared to pay.

It also shouldn’t be forgotten that we are talking about the debt of sub-investment grade companies; true, leveraged loans have had a recovery rate of 80% in the event of default, which is much higher than the 40% recovery rate seen in the high yield market, but senior loans are still rated B/BB and credit default risk is therefore very real. We are therefore continuing to be very selective in choosing which new loans coming to the market we should invest in. Quality is key, more so now than ever.

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iTraxx Index- A brief explanation

In response to a recent request and the ever increasing spotlight that the iTraxx indices find themselves under I thought I’d write a quick note to try and shed some light. The indices first came into being in Europe back in June 2004 when it was felt that the bond markets would benefit from the creation of a liquid index reflecting the ever growing credit default swap market (CDS) . The index is not dissimilar to those found in the equity and traditional bond markets such as the Dow, FTSE or Merrill Lynch Bond Indices.

The iTraxx index family in Europe is principally made up of the three indices; iTraxx Europe Main, iTraxx Hivol and the Itraxx Crossover. Each has its own set of rules to define which bonds are suitable for inclusion. The Main Index is composed of:
- 125 equally weighted investment grade entities,
- The Hivol 30 – the more volatile investment grade names and
- The Crossover 45 – sub investment grade names (those credits that the rating agencies believe are most at risk of default)

Each of these indices has a life of either five, seven or ten years. The indices are then created every six months (known as the roll), based on a poll which attempts to identify those bonds (subject to the criteria) that bond traders believe are most liquid and should be included (try repeating that at speed!).

The indices have proved incredibly popular amongst banks and investors alike as they offer all the benefits of a liquid instrument that enables investors to express a view on a portion of the credit markets through buying or selling the relevant index. As a result volumes have been climbing and nowadays account for a majority of trades within the credit derivatives space. Volumes this week alone are expected to be nearly €200bn!!

Until this week’s equity market sell-off we had seen nothing but an upward trending market for the indices since the previous roll back in September 2006. However, the increased volatility and price action in the equity markets has had a significant impact on the Crossover index (you’d expect this index to be the more volatile of the three) , and to a lesser degree the Main & Hivol. Interestingly so far ‘traditional’ bonds have been largely unperturbed by the increased volatility in the indices. The question many are now asking is whether the rest of the market will follow the iTraxx indices lower ?

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