A Harder Season for Bonds?
By Diane Vazza
Although winter frost has clearly arrived, fixed-income markets have yet to shake off their dreamy, midsummer, hypnotic state and awake to looming risks on the horizon.
It is most impressive that the bond market has maintained relative composure despite a barrage of negative news for bonds: hurricane damage, high-profile downgrades and defaults, a steady stream of interest-rate hikes by the U.S. Federal Reserve and other central banks around the world, energy-price spikes, a relative lack of fiscal conservatism, and continued merger and acquisition activity. The market's reaction generally reflects the lack of yield plays.
Spreads remain compressed by strong demand for duration and a lack of risk aversion, and investors appear headed for another year of anemic, low single-digit bond returns in all regions outside the emerging markets in 2006.
The current benign conditions heighten the risk, however, that an adjustment -- when it occurs -- could prove abrupt and relatively speedy. In spite of the overall continuity in tone, we note a few key changes in the overall environment.
First, economic growth appears on a stronger footing in the major markets, with indicators of economic activity showing advances in Europe and Japan, in tandem with continued strong growth in the U.S. The U.S. consumer and the Chinese producer again acted as the key global players in 2005, but both are set to take a breather.
Second, monetary policy appears more synchronized in the developed markets than in past quarters. The Fed has reached the tail end of its tightening cycle, with two more 25-basis-point rate hikes anticipated by Standard & Poor's economists. The European Central Bank began tightening this winter and is due for one more action in the spring, and even the Bank of Japan has issued statements that it will gradually curtail its longstanding policy of liquidity infusion.
Third, having focused single-mindedly on deleveraging and cost control in 2003 and 2004, corporations appear more eager to put their surplus cash to work, either through acquisitions or returning it to shareholders via dividends and cash buybacks.
Looking ahead to 2006, we see a handful of themes. First, both yields and spreads are expected to rise from their current compressed levels.
Second, rising yields imply that returns on conventional fixed-income securities are likely to be mediocre in 2006.
Third, credit quality outlook shows mixed prospects by region. In the U.S., risks will likely escalate as the year progresses. In Europe, a rising tide of mergers and acquisitions threatens to undermine this year's gains in credit quality. Emerging-market credit quality is also expected to decline from its record sizzling pace in 2004.
Fourth, defaults should turn around from their cyclical lows in 2006, but remain well below long-term averages. More significant default pressure is expected to emerge in 2007, from the churning generated by the 2003-2004 surge in low-grade issuance.
Fifth, issuance will likely perk up as corporations around the globe use up their liquidity buffers.
There are a few principal risks to the forecast. A sharp retrenchment by the U.S. consumer, potentially in response to a sharper-than-expected drop in housing-related asset prices, could create a vicious cycle in which firms reduce hiring and capital expenditures sharply.
Second, the U.S. dollar could depreciate abruptly, stemming from sudden reversal of financial flows into the U.S.
Third, a surge in cash-depleting and eventually debt-financed M&A activity could have a deleterious impact on credit spreads and credit quality.
Fourth, inflation could accelerate, or there could be greater-than-anticipated pass-through of higher commodity prices into overall prices. We caution that any hints of rising core inflation could cause a rapid yield backup.
In conclusion, emerging markets remained the stars in terms of total fixed-income returns, with sovereigns racking up 10.4% -- and corporate debt 8.3% -- in the year to date through Dec. 13, according to the Merrill Lynch indices.
NO REWARD FOR RISK.
U.S. bond returns look fairly anemic with all asset classes -- with the exception of asset-backed securities -- showing a vastly reduced performance compared with 2004.
Worse, it appears investors are not receiving compensation for risk-taking, as evidenced by the negative 16.8% returns in distressed debt. In contrast, equity market gains look superior, a typical phenomenon for this stage of the tightening cycle.
In all, we expect the status quo to persist for fixed income in 2006.
Diane Vazza is managing director of Global Fixed Income Research for Standard & Poor's