Bond Outlook by bridport & cie, October 27th 2010

As we suggested last week in our use of the champagne cascade metaphor, the glasses representing the first assets to “benefit” from so much money creation, Treasuries, are overflowing. Investors are now looking to alternatives, as demonstrated, for example, by a switch in ETF demand from government to corporate bonds. Ever since the first round of quantitative easing in the USA, we have warned that printing dollars must eventually lead to inflation. QE2 is about to be unleashed to the tune of an estimated USD 100 billion per month – to put that into context, it is a run rate greater than the US budget and the current account deficits. The expectation of QE2 has made investors much more aware of the risk of US inflation, evidenced most palpably in the current weakness of the USD. 10-year yields touched a bottom at the end of August. TIPs have just been auctioned at a negative yield, and, whilst a sudden breakout may not necessarily be imminent, it does look as though long-term rates can only move higher.

Another of our persistent themes is that the situation in Europe is quite different from that of the USA:

* austerity programmes versus flooding the market with liquidity

* internal imbalances in the euro zone versus both internal and external imbalances in the USA

* little expectation of QE2, versus massive QE2 (despite the Chancellor’s comments – see Focus – the likelihood of QE2 in the UK is declining as the economy is proving surprisingly robust)

* economically driven, rather than artificial, Government-induced, inflation

* a notable new phenomenon is a rising trend in EUR, and to a lesser extent GBP, short-term yields (but not in CHF), versus short-term yields in USD anchored very close to zero

The last of these points suggests that 3 to 4 year EUR corporates may no longer be the optimum maturity focus. Better perhaps to split a corporate fixed-income portfolio into two parts: cash or cash equivalents and longer-term (we would suggest around 7 year) bonds, a typical “barbell” approach. A similar recommendation for GBP may eventually become appropriate.

Cash equivalents would be floaters and, possibly, perpetuals. We must however warn that perpetuals, often with a degree of structuring, have a limited liquidity reflected in wide bid/offer spreads, suggesting that they are not suitable for short-term holdings or for less sophisticated investors. This is an important consideration, as one of the major arguments in favour of being in cash is that investors will be able to redeploy quickly to longer-term maturities when yields increase. Thus, although perpetuals can represent a good way of participating in rising short-term rates, this may not be an opportune time to expand holdings in them. In fact, since we recommended these bonds during the summer, perpetuals have performed well and profit-taking may be in order, especially for those trading over par. Holders should also be aware of the potential for a small number of Tier 1 issues to be called at par should the borrowers decide to implement their put options, and in this context, it is important that the terms of any issue are fully understood before any action is taken.

The growing sense that the world economy is at a turning point is partly a reflection of the likely economic implications of the outcome of the forthcoming US elections. Primarily, there are two arguments for the USA to move more in the direction of fiscal responsibility. One is that the Administration will eventually reach the conclusion that the policy to date of flooding the market with liquidity is not working, so the alternative of European-style austerity will be worth considering once there is little further potential downside in Presidential popularity. The other is that the influence of the Tea Party gang will encourage “smaller government” and therefore a lower level of entitlements.

Focus

US: the Treasury sold USD 10 billion 5-year TIPS at a negative yield for the first time

Commodities: cotton soared to a record high, as a cold spell threatened to damage the crop in China, the world’s biggest user of the fibre

G7: the share of the global economy of the G7 will fall below 50% in 2012, from about 70%in the mid-1980s

Germany: GDP to expand 3.4% this year, more than doubling a 1.4% forecast from the spring. Surprisingly, the IFO index has continued to rise

Europe: SMEs reporting a worsening access to bank loans fell to 24 % from 42% six months ago

UK: Gilts fell after the Chancellor said the BoE is free to "deploy monetary-policy tools"

USA: the index of leading indicators rose in September for the third straight month, signalling the recovery will extend into 2011

Ireland: the bond market may get a boost as pension funds lobby for a rule change that would increase their purchases of domestic debt

Asia: currencies weakened after China’s first interest-rate increase since 2007 dimmed the outlook for spending in the No.1 export market for South Korea, Taiwan and Thailand

Recommended average maturity for bonds (corporate/government)

Reduce the place of government bonds in portfolios, and barbell in corporate bonds in EUR.