And our bond portfolios have a defensive bias. Bond market returns have generally justified our caution. We continue to think equities will outperform bonds but our bond portfolios have assumed a little more risk as over-demanding bond valuations have tended to fall back.
With bond markets looking expensive and the Fed, the ECB and the Bank of England moving towards monetary normalisation, investors have reduced duration risk by selling emerging country bonds -which is generally the case in this sort of environment- but also corporate debt, a rarer occurrence. Private bond maturities had lengthened in recent years and many yield-seeking investors had accumulated duration risk which needed to be reduced as soon as serious worries over interest rate trends surfaced. In fact, widening spreads since January were more the result of shifting perceptions of monetary policy than a downturn in upbeat fundamentals. The notable exception is emerging country debt where poor returns were exacerbated by a serious of specific problems in countries like Brazil and Turkey.
May’s Italian crisis amplified peripheral country and company spreads, making yields more attractive and causing us to slightly up exposure to these segments in our bond funds. Previously, markets had completely brushed off Italian political risk, even when the populist parties formed a ruling coalition, but then overreacted at the first signs of friction between the President and the new administration. And yet the risk of Italy leaving the eurozone is still virtual as none of the parties in power had campaigned for this in the lead-up to elections. A majority of Italians are attached to the single currency and any euro exit would mean leaving the European Union, a very costly move that no administration is likely to risk.
Over-demanding bond valuations have tended to fall back
Negative pressure on emerging country debt persists. Looking beyond local political risk in leading countries, the US economic policy shift marks a serious break for emerging bonds. Some of the liquidities from the Fed’s quantitative easing were invested in the emerging zone. But now the Fed’s balance sheet is to shrink -which means that investors will have to mop up the bonds the Fed had been buying- and US Treasury issuance is set to rise to fund the economic stimulus plan. Emerging debt could well be penalised by a Treasury bond avalanche that private investors will have to take up. Spreads have duly widened by around 75bp year to date, an indication that the environment has changed.
All in all, we believe bonds are starting to offer more attractive yields and we have marginally re-exposed portfolios. We believe that by reducing exposure to corporate debt, investors have, at least partly, discounted the end of European quantitative easing and the new US policy stance. But we think it is too early to return to significant exposure levels as a powerful capital pull towards the US is looming and there will be the usual disruption that follows the end of ultra-expansionist monetary policy. Bond markets could still see some choppy trading ahead.
Head of asset allocation and sovereign debt
This analysis is an extract from the first House View published by Edmond de Rothschild.
This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes.
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