Whilst there is undoubtedly a clear willingness on the part of the US Federal Reserve to re-engage the printing presses (and similarly dovish noises emanating from certain members from the MPC in the UK), it is difficult to be overly enthused at the prospect of lending to the UK or US govt at less than 3%.
This nervousness is more acute with respect to the gilt market where, in contrast to the US, the macroeconomic data has been almost unambiguously firm in recent months, with inflation proving to be stubbornly sticky at over 1% above the MPC target level of 2%.
Concern around the expensiveness of bond markets has been one of the principal drivers of our portfolio positioning for most of this year, with an emphasis on preserving client capital (in the event that yields rise).
Targeting alpha
A more succinct way of summarising our current view on fixed income markets is that we prefer to focus on generating performance through what we would term alpha, rather than simply market beta.
A recent example of this type of trade arose in a cross-market trade we implemented. In early September we viewed the market as wrongly pricing Australian Government debt, in that its domestic economy was sufficiently strong that we believed rate rises were imminent. Normally we could just have sold the Australian market. At the same time we saw equivalent New Zealand debt as too cheap – structural headwinds, a faltering recovery and an earthquake all adding to the mix.
We were able to buy New Zealand and sell Australia leaving the level of overall interest rate exposure in the fund unchanged (and hedge out all the currency risk, something we do as standard). Thankfully our views proved correct and New Zealand bonds performed very strongly relative to Australia.
Stock-specific opportunities
With peripheral spreads likely to continue to exhibit significant volatility as the political machinations of the European Union determine how best to resolve the crisis, it is our expectation that we will see further opportunities to exploit cross-market relative value over the coming months.
This does not just apply to opportunities between sovereign markets, but also between sovereigns and credits. One of the anomalies that exist in European credit markets concerns how many (predominantly domestically focused) credits continue to trade relative to Bunds, rather than their own sovereign. For example, we were recently able to rotate our exposure from low-single-A rated Enel (an Italian utility) into AA- rated Italian government risk for a drop in yield of approximately 55bps.
Equally there remain great opportunities within the corporate bond market. Although sometimes we have to wait a while for these to crystallise, there is no doubt that breadth and depth of credit resource, combined with sound credit analysis can unearth stock-specific opportunities, particularly in the high yield arena.
