At the market level, the year-to-date return of investment grade credit has been staggering – from 7.5% in the US to over 11% in sterling. High yield indices are up over 10% and subordinated financial debt returns are pushing 20%. Credit spreads have narrowed over the summer, between 30bp and 40bp in investment grade and 30bp to 70bp in US and European high yield respectively.
Unattractive yields…
Spreads are not yet quite as tight as they were in mid-2011 but are currently close to their tightest levels of the year. With already low government bond curves, this means total yields in fixed income are as unattractive as they ever been.
A consequence of monetary reflation and persistently low official interest rates may be that spreads grind even lower, especially given that supply continues to be overwhelmed by demand, but even then it is hard to think that passive returns over the next year will be anything like returns so far in 2012.
There is still some juice in the sub-investment grade part of the market where yields in Europe are still above 8% on average, which is still attractive on an asset class with average bond duration of just three-and-a-half years.
However, we believe that good returns can still be enjoyed in bond markets depending on the approach one takes. More than ever, it is important for investors to gain access to all parts of the bond market. Active allocation between different bond sectors (government bonds, corporate bonds, high yield and emerging market debt) combined with active allocation of interest rate, inflation and credit exposures is a way of beating the constraints offered by low market yields.
…but anything other than boring
Investors in bonds have enjoyed very strong returns over the past couple of years. Hanging on to those returns means a more strategic and a lower market-beta approach is required.
There will be plenty of macro themes to drive asset allocation decisions, including the next phase of the euro crisis, the US election, the fiscal cliff and how that is dealt with, rising commodity inflation, the challenges of managing China’s economy, and political and economic change in other emerging markets.
Although yields might be very low, for sure, bond markets will not be boring.
