The scramble for income as interest rate hikes loom

Corporate bonds have been a popular destination for investors over the past couple of years. The three-year bear market in equities prompted investors to seek solace in the perceived safety of government and then corporate bonds.

This rise in demand pushed up capital values in 2002 but led to a fall in yield and therefore the income received by investors. Since March 2003, however, yields in Europe and the US have begun to rise again due to expectations of an economic recovery and thus a rise in interest rates. In November, Australia and the UK became the first major countries to raise their interest rates.

But while yields have been rising since March, capital values have generally fallen back as investors have increasingly turned to equities following the recovery in stock markets. This is not unusual as the yield and price of bonds move inversely to each other.

As the yield increases, the price of a bond declines and as the yield falls, the price rises.

The extent of the movement in the yield and price depends on several factors, including the maturity and type of bond. It is estimated that if yields rise 0.5 per cent, the capital value will fall by between 2 and 3 per cent.

Interest rate hikes

Eric Adriaens, manager of the ING (L) RF International fund, expects the yield on 10-year bonds to rise by 50 basis points in 2004. This is because of expectations that the US Federal Reserve and the European Central Bank will raise interest rates in the second half of this year.

“There was a dramatic fall in yields on 10-year bonds in 2002 but subsequently there has been a recovery,” says Mr Adriaens. “The 10-year US bonds started 2003 with a yield of

3.75 per cent. By early December, the yield had risen to 4.30 per cent as economic prospects had improved and we believe they will finish 2004 just below 5 per cent.

“In early December, 10-year euro bonds were yielding 4.40 per cent and we expect a rise of about 0.50 per cent in 2004.”

To try to gain a higher level of income, Mr Adriaens says the fund has invested about 5 per cent of the portfolio in OECD emerging markets bonds, such as Hungary, Poland and Mexico. The exposure is low because of the greater volatility of bonds in these countries. This approach has beaten the index over one, three and five years.

Mr Adriaens says that 63 per cent of the fund is invested in euro bonds while it has an 18 per cent exposure to US bonds. “We are positive about the euro currency. But we are underweight duration for both US and euro bonds. This is because we expect yields on 10-year bonds to increase over the coming months. By focusing on shorter duration bonds, we believe we have lowered the risk level of our fund.”

He even believes corporate bonds may outperform government bonds this year. “We expect economic growth to gather speed in 2004, which will benefit corporate bonds. But corporate bonds had quite a large rally last year so we have reduced our allocation to them.

“From the start of 2003 to December, our allocation in corporate bonds went from 35 per cent to 18 per cent.

“We have made a nice profit by reducing our exposure. There has been strong demand for corporate bonds but at some point this will cool down.”

Global defaults down

The market has been helped by the fact that global default rates in 2003 displayed a substantial drop from the record levels posted in 2002. In 2003, global defaults dipped below the long-term average of 5.17 per cent at the end of November. A total of 115 defaults were recorded by the end of November on rated debt obligations worth $51.6bn (E42.3bn). The US accounted for 88 defaults and the EU seven.

Keith Swabey, client portfolio manager of the JPMF Eur Global Bond A fund, a solid performer over one and three years, agrees that yields will rise, but says this may not happen until the second half of 2004.

“The US Federal Reserve will only raise interest rates if inflation gets out of control or economic growth is too high,” he says. “But there is so much spare capacity in the US that inflation will not be affected by growth rates of 3 or 4 per cent.

“The Federal Reserve will also not want to destabilise an economic recovery by increasing rates too soon.”

Mr Swabey argues that US government bonds have outperformed Europe because when Japan has intervened to support the yen it has tended to buy dollar bonds. This has kept the price of US bonds relatively high compared with Europe and it has also kept yields lower. But in the medium term Mr Swabey believes European bonds will outperform US bonds. He expects yields on European bonds to rise next year but not as much as those on US bonds.

The risk to investors, according to Mr Swabey, is an economic recovery that turns out to be weaker than analysts expect. “But if this is the case, everyone will be caught offside.”

He reveals his fund has reduced exposure to non-government bonds, such as agencies, mortgage and corporate, from between 20 and 25 per cent of the portfolio to 8 per cent because JPMF believes the good news is already priced into bonds.

Corporates outperform

“Corporate bonds will outperform government bonds this year. The question is how much extra return will an investor get for the risk,” says Mr Swabey. “If an investor could invest anywhere at the moment regardless of risk then corporate bonds is the place. There is economic and profit growth, which will benefit corporate bonds, and the number of blow-ups has declined. But the level of outperformance of corporate bonds will decline next year.

“Over the next 12 months, we expect total returns for government bonds to be 2 to 2.5 per cent. We anticipate 3 to 4 per cent for investment grade bonds and 6 to 7 per cent for high yield. This compares with 2 to 4 per cent for government bonds this year, 7 to 8 per cent for investment grade bonds and 20 per cent for high yield.”

Government bonds

Johnny Debuysscher, manager of the PAM (L) Bond Universalis Cap fund, the best performer over five years of Europe’s biggest bond funds, takes an opposing view, favouring government bonds over corporates.

“We began 2003 with 80 per cent of the fund in corporates but we had reduced this exposure to 60 per cent by December because of the narrowing of credit spreads.

“The spreads reached between 120 and 130 basis points at their peak but are now down to 80 basis points. We do not feel 80 basis points is a wide enough spread to justify the extra risk.”

David O’Shea, portfolio manager of the Pioneer International Euro Bond fund, says it has been investing in “peripheral” markets to try to gain extra return. This has been motivated by the weakness of the US dollar.

“One of our biggest positions in 2003 was Australia as a play against the US dollar. We have been trading the euro and the Canadian and Australian dollars against the US dollar,” says Mr O’Shea. “Another theme has been going long Asia and Japan. We have been buying bonds in peripheral markets such as Norway and Sweden because of the strength of the fundamentals in those countries.”

Cautious approach

Kobus Human, managing director of Insinger de Beaufort, says his firm has reduced the allocation to bonds in its portfolio, but only slightly. “We do not think yields will rise much further but we also do not expect a major sell off in bonds either.”

He stresses, however, that the dynamics of bonds in the Europe, the US and Japan are very different. “Japanese bonds have low yields while the economy is showing signs of moving out of its deflationary phase. Whether Japan moves into inflation or not, bond yields are likely to rise.

“We think there will also be a pick-up in yields in the US, but we are not bullish about the outlook for the US economy. We think there will be lots of issuance of bonds to pay for the current account and trade deficit in the US. There has also been a slowdown in

capital inflows into bonds. While yields will rise, they will probably not go through 5 per cent.”

Mr Human believes bonds in Europe are looking more enticing for investors than US fixed interest. “It is interesting that European bonds are yielding more than the US at the moment given that the continent is facing deflation, the strong euro is squeezing inflationary pressures and economic growth is weak.

“As inflation has fallen to 2.2 per cent in Europe, the real return on bonds is just over 2 per cent. If Europe heads into deflation, the real return will approach 3.5 per cent. The total return is about 2 per cent at the moment. European bond yields are close to the level where we would want to invest again.”

In the second half of next year, the situation will change again, believes Mr Human. He argues that the economic recovery in the US is not as strong as many analysts think and therefore yields will come down again. Mr Human says that US bonds will be a good investment next year before yields start falling again.