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Categorized | Capital Markets

High-yield bonds benefit from rotation


Posted on December 21, 2013

Anyone looking at the stunning rise in US equities and losses in bonds this year would conclude that a ‘great rotation’ between the asset classes has defined 2013.

From a performance perspective bonds have been truly buried by equities.

    The S&P 500 sports a rise of some 27 per cent since January, while the bond market’s benchmark, the Barclays Aggregate index is set for its first annual negative total return since 1999, with a decline of around 1.8 per cent.

    Looking solely at the scoreboard, however does not tell the full story and illustrates how, in spite of Wall Street’s mantra of a great rotation out of bonds into equities, demand for yield that bestows a fixed income remains robust.

    “The great rotation is more of a myth than reality,” says Joyce Chang, global head of fixed income research at JPMorgan. “Bond funds have received positive inflows for the year and primary issuance has set new records this year. The rotation has been a US retail phenomenon, it’s not global.”

    Certainly, holders of long-dated US Treasury and inflation-linked bonds are nursing hefty losses and there have been outflows from these sectors as they have borne the brunt of preparing for the Federal Reserve’s taper of quantitative easing, which was finally announced this week.

    As we near year end the 10-year Treasury yield sits just shy of 3 per cent, representing a near doubling from its low in May, ahead of the Fed trimming its monthly bond buying by $10bn to $75bn in January.

    No matter the large rise in the benchmark yield for the broader fixed income universe, the taper tantrum of 2013 has failed to stem money piling into higher yielding corporate securities.

    Beyond positive net mutual fund flows into US investment grade and high-yield bonds this year, according to Lipper, one only has to look at the $100bn of orders for Verizon’s record $49bn bond sale in September to see that plenty of investors desire income from bonds rather than seeking the opportunity of capital appreciation from equities.

    “There has been a rotation out of Treasuries and investment grade and high-yield bonds have been the beneficiaries,” says Edward Marrinan, head of credit strategy at RBS Securities.

    A burning question is whether corporate bonds retain favour as the Fed’s taper gathers pace during 2014.

    There are reasons to think that the preference for yield will remain robust and not just because more baby boomers are retiring and seeking income.

    Despite strong sales of corporate and government bonds in recent years, annual net issuance of financial assets currently hovers around $1tn, well below the $3tn to $4tn sold in the years before the crisis.

    Ms Chang says apart from municipal bonds, US retail investors do not dominate fixed income, rather it is institutional investor-based, led by pension funds, insurers, sovereign wealth funds and money managers. These investors are seeking to own quality paper in an environment where net issuance of debt remains well below the level seen before the financial crisis.

    The dearth of quality bonds means the end of Fed support for the bond market may not be a big event, particularly if the 10-year Treasury yield only rises modestly to around 3.5 per cent next year as many bond strategists predict.

    At such a yield level US government bonds will look appealing against a backdrop of low inflation and modest economic growth when compared with other leading sovereign counterparts such as Japan, Switzerland and Germany.

    “Unless you have a strong conviction that rates are going up rapidly, there is still enormous demand for bonds,” says James Sarni, managing principal at Payden & Rygel.

    This view is also enhanced by the fact that equities no longer look so appealing after their big run this year, and whenever the Fed has pulled back from QE in the past, stocks have not fared so well.

    “It’s hard to see a great rotation as you can’t look at equities and say they are a cheap asset class,” says Mr Sarni.

    In truth, bonds will continue to play a big role across investment portfolios and may stand to benefit from any turbulence for equities as QE steadily tapers.