The great question for the bond market in 2014, as it has been for the past three years, is when? When will the Federal Reserve finally call a halt to the printing presses and taper its gargantuan monthly purchases of US government bonds. If recent spikes in yields for US government debt are any indication, then the market is expecting action relatively quickly, which will have a huge impact on the demand for different classes of fixed-income securities as the year progresses. However, in a sense, it is not just the Fed's actions that will determine the outcome. Simply put, investors have allocated larger than average portions of their portfolios into bonds, and it could be argued that a technical readjustment in order to correct this imbalance is long overdue, now that economic fundamentals have taken a swing upwards.
Dull sovereigns
Government bonds had a generally poor 2013, which, unusually, had been called correctly by the vast majority of analysts and the investment commentariat. The numbers speak for themselves. To date, US Treasuries have fallen in value by an average of 2.3 per cent since the start of the year, while benchmark 10-year gilts have experienced wild swings.
For example, at one point gilts had reached lows of 1.6 per cent, before soaring to more than 3 per cent. Yields are currently stable at 2.8 per cent but the curve is clearly upwards. These movements reflect the market's now settled view that bond purchases will eventually be reduced. (At the time of writing, the Federal Reserve Board meeting on 18 December will discuss the possibility of scaling back bond purchases.)
It is not only the Fed's actions that will determine the bond market's performance in 2014, but increasingly the state of the underlying economies of the developed world. The signs so far are that a recovery in certain countries will continue, at least through the first two quarters of the year. The basis for this optimism was a clutch of late data showing a definite increase in manufacturing activity in the sickly eurozone, as well as a greater than expected fall in US unemployment figures. That is probably why many commentators are expecting essentially flat yields for next year. For example, Capital Economics is forecasting that gilt yields will stay flat at about 2.75 per cent, not much below the current yield of 2.9 per cent. Meanwhile, many of the City's bond market makers are working on the assumption that UK bank rates will still be below 2 per cent by the end of 2016, according to sector observers, which for the bond market implies that yields next year will hover at around 3.25 per cent for benchmark gilts.
The pick up in manufacturing growth is a definite sign that the flow of goods and exports is speeding up. The most obvious effect of this on the bond market is in the absence of fear. In benign circumstances, there is little appetite to hold 'safe' government debt. The beneficiary of this switchover has been the equity markets in the three economies - the US, the UK and Germany - where signs of recovery are the most tangible at the moment. There doesn't seem to be much sign that the switchover has meant more cash flowing into cash, which is a sign that despite the possibility of bond purchases and economic growth, investors still aren’t keen to risk the low interest rates available on cash.
Shinier corporates
The corporate bond market will be just as sensitive to the vagaries of interest rates as their sovereign equivalents. However, the greater range of asset quality will determine which way the market moves. There are also the specific conditions related to individual bond markets that have to be taken into account, but developments in Europe should be watched closely.
It has been true for some time that the spread between higher-rated corporate bonds and the equivalent government bond is narrower than looks comfortable. For A-rated securities issued by large blue-chip corporations, the marginal cost of issuing new debt has never been better - with the average spread over gilts hanging steady at about 100 basis points (bps). This is considerably tighter than would be expected - perhaps 200bps is a more usual historic spread. This very finely balanced situation is explained by the ongoing hunt for decent levels of income, but objectively assessing value and pruning back positions that have outrun their historic valuations should be an investor's overriding priority in 2014.
For example, there is definite evidence that lower-grade junk bonds and higher-yielding corporate bonds look decidedly overvalued at the moment, particularly for European issues. Running yields on bonds that should yield 7 per cent or higher have fallen as low as 4 per cent over the course of the past few years. This is quite clearly unsustainable as higher-yielding bonds always react more negatively to higher interest rates than higher-quality corporate bonds. Sudden rate changes aren't in the pipeline in Europe, either, but the effect of rotation from bonds into equities could have much greater consequences. To begin with, European shares are looking much better value, with the possible exception of the Dax, than their counterparts in the UK and US, and should investors seize the opportunity to free up cash and put it into shares, high-yielding bonds will be affected disproportionately.
The outlook for the London Stock Exchange's retail bond market (ORB) is harder to gauge. Issuance may be a problem after a year when companies' options for finance were broadened with the extension of the Funding for Lending (FfL) scheme. ORB competes directly with FfL for the attention of small- and medium-sized companies. As a consequence, issuance fell in 2013 and only eight wholly new bonds were launched compared with 16 in 2012. On the plus side, the demand was strong and all the issues were over-subscribed by some margin.
There is also increasingly heavy competition with the emerging 'mini-bond' market where companies solicit small loans direct from investors in exchange for generally higher coupons (and considerably more liquidity risk) than can be found on ORB. However, one advantage that ORB investors have experienced is that the market has fluctuated far less than either the institutional or gilt bond markets. That could be a result of lower liquidity as it shows that retail investors are happy to buy and hold ORB bonds until redemption.
Returns will be a problem
The main problem though is, given the brightening economic backdrop, how bond investors will generate an adequate total return from the fixed-income market. Now could be the time to start looking seriously at floating rate notes (FRN).
FRNs are not index-linked bonds but have features that protect income against higher interest rates by varying the coupon depending on the level of the underlying interest rate. Issuance of FRNs has surged this year, with the asset class estimated to have made 10 per cent of total bond issuance in 2013, compared with only 3 per cent the previous year. The professionals are starting to factor in the effect of higher interest rates.
For retail investors, the most obvious FRN choice is the RBS floating rate bond (RBLI, ISIN: GB00B4RM3T66), which pays a minimum fixed return of 3.9 per cent, or three-month Libor, whichever is greater, and runs to maturity in 2022. Fortunately, it can be bought and sold through the ORB market, which isn’t the case for most FRNs. In addition, there is also US-traded iShares Floating Rate Bond ETF (US: FLOT) that tracks short-dated US interest rates.
Overall, expect plenty of headwinds next year in the bond market, although this should be tied to the effects of positive economic developments. This ultimately, in spite of the technical challenges it poses, is the best guarantee that credit quality stays solid and bond investors eventually get their money back - just don't expect to make a fortune this time around.
