November 2013 Rate pressures have softened -along with growth expectations, triggering gains across fixed income markets. Core government yields have retraced a substantial amount of the recent sharp rise in rates that ended in September. Policy rate expectations now reflect a more dovish view about the front end of the curve. Citi analysts view these trends as merely a reprieve. European rates - are likely to track the direction of US Treasuries, though our analysts expect the magnitude to vary based on growth prospects. Citi analysts are reluctant to make too much fuss about the recent decoupling of 10-year German and US bond yields, but the trend underscores their conviction that Bunds are likely to continue outperforming both Treasuries and Gilts due to diverging growth prospects. The recent rally in rates - has produced a window of opportunity for investors to reduce exposure to long duration positions and marginal credits in emerging market debt. Our analysts maintain a constructive view on high yield bonds. While fixed-rate debt is likely to outperform floating-rate loans in the near term, the latter is poised to benefit once interest rate concerns resume in the New Year. Sectors 12 Months View Investment Rationale Dev. Market (Core) Sovereigns EU Periphery Sovereigns* Emerging Market Sovereigns High Grade Corporates High Yield Corporates Underperform Market perform Underperform Market perform Outperform Citi analysts core rates to be constrained near term, but unlikely to decline much further from here; Intermittently higher rates into 2014; Bunds poised to outperform UST and UK Gilts Risks are ring-fenced, for now; Growth and banking concerns persist, but dearth of negative catalysts near term, improved financial conditions, and potential ECB LTRO support spreads Fed s decision to delay tapering has bolstered EM; Gains, though, to be short-lived due to weaker fundamentals, volatile FX, and gradually rising US rates into 14; Use rally to shed long duration positions and lighten exposure to fragile credits Expect only modest gains near term; Favor defensive duration (3y-7y); Prefer financials vs. non-financials (US & core EU) Valuations fair relative to fundamentals, but gains will be more challenging as rates rise in 14; Diversify with bank loan debt *EU Periphery Sovereigns include bonds from countries such as Greece, Ireland, Italy, Portugal and Spain.
Important Information Citi analysts refers to investment professionals within Citi Research ( CR ), Citi Global Markets Inc. ( CGMI ) and voting members of the Citi Global Investment Committee. This document is based on information provided by Citigroup Investment Research, Citigroup Global Markets, Citigroup Global Wealth Management and Citigroup Alternative Investments. It is provided for your information only. It is not intended as an offer or solicitation for the purchase or sale of any security. Information in this document has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the information, consider its appropriateness, having regard to their objectives, financial situation and needs. Any decision to purchase securities mentioned herein should be made based on a review of your particular circumstances with your financial adviser. Investments referred to in this document are not recommendations of Citibank or its affiliates. Although information has been obtained from and is based upon sources that Citibank believes to be reliable, we do not guarantee its accuracy and it may be incomplete and condensed. All opinions, projections and estimates constitute the judgment of the author as of the date of publication and are subject to change without notice. Prices and availability of financial instruments also are subject to change without notice. Past performance is no guarantee of future results. Investment products are (i) not insured by any government agency; (ii) not a deposit or other obligation of, or guaranteed by, the depository institution; and (iii) subject to investment risks, including possible loss of the principal amount invested. The document is not to be construed as a solicitation or recommendation of investment advice. Subject to the nature and contents of the document, the investments described herein are subject to fluctuations in price and/or value and investors may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal the amount invested. Certain investments contained in the document may have tax implications for private customers whereby levels and basis of taxation may be subject to change. Citibank does not provide tax advice and investors should seek advice from a tax adviser. Citibank N.A., London Branch is authorised and regulated by the Office of the Comptroller of the Currency (USA) and authorised by the Prudential Regulation Authority. Subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. Our firm reference number with our UK regulators is 124704. Citibank International plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Our firm reference number with our UK regulators is 122342. Citibank N.A., London Branch and Citibank International plc are licensed by the Office of Fair Trading with licence numbers 0001486 and 0482552 respectively to extend credit under the Consumer Credit Act 2006. Citibank N.A., London Branch is registered as a branch in the UK at Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB. Registered number BR001018. Citibank International plc has its registered office at Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB. Registered number 01088249. Citibank N.A., Jersey Branch is regulated by the Jersey Financial Services Commission under the Financial Services (Jersey) Law 1998 for the conduct of investment business and under the Banking Business (Jersey) Law 1991 for the conduct of deposit taking business. Citi International Personal Bank is registered in Jersey as a business name of Citibank N.A. The address of Citibank N.A., Jersey Branch is P.O. Box 104, 38 Esplanade, St Helier, Jersey JE4 8QB. Citibank N.A. is incorporated with limited liability in the USA. Head office: 399 Park Avenue, New York, NY 10043, USA. Citibank N.A. 2013. CITI, CITI and Arc Design are registered service marks of Citigroup Inc. Calls may be monitored or recorded for training and service quality purposes.
Developed Markets Government Bonds Core government bond yields have retraced a substantial amount of the sharp rise in rates that ended two months ago. Since September, the rally has bolstered gains across risk assets, particularly in spread products and higher beta credits. Long-term yields declined from a two-year peak, though they have consolidated at much higher levels relative to the first half of the year (Fig. 1). Rate pressures have softened along with growth expectations. Forward curves decisively flattened and overnight policy rate expectations (i.e., futures contracts, overnight index swaps) now signal a more dovish view about the front end of the curve. This shift now aligns with our long-held conviction that short-term rates in the core markets are likely to be well-anchored into the second half of 2015. Figure 1: Core rates have retreated from 2-year highs Source: The Yield Book. The delay in Fed tapering and relatively soft data should restrain any material backup in yields near term. However, these outcomes are already well-discounted into current market levels. Indeed, our analysts firmly believe that rate expectations have simply become too one-sided. That doesn t mean 10-year US yields are poised to make another run at 3.0% (core rates are more likely to be range-bound for the rest of the year). But unless you believe that tail risks will accelerate, or another recession is in the cards, then there appears to be limited scope for long-term rates to decline much further from here. This is especially true in the US, where improving fundamentals, bond fund outflows, and policy normalization should discourage overzealous longs. In our view, yield curves are poised to resteepen once the next US fiscal impasse is resolved, allowing core rates to resume their upward drift. European rates are likely to track the direction of US Treasuries, though our analysts expect the magnitude to vary based on growth prospects. For example, even though a more sustainable UK recovery has become evident, Eurozone growth is lagging and disinflationary pressures may warrant low ECB rate. Our analysts are reluctant to make too much fuss about the recent decoupling of 10-year German and US bond yields (the spread has merely reverted to 3Q levels), but the trend certainly underscores their conviction that Bunds are likely to continue outperforming both Treasuries and Gilts.
Emerging Markets Government Bonds Emerging market sovereign bonds (hard currency and local debt) continue to benefit from the renewed risk appetite due to improved financial conditions in advanced economies. US dollar-denominated EM bonds gained a 2.3% last month, which boosts returns to nearly 5.0% since the beginning of September. Local currency EM sovereigns generated 0.6% of total return last month, or about 6.7% since September (unhedged to USD). That said, performance across the emerging markets has differed vastly. Dual-deficit countries (which bore the brunt of the recent sell-off) have rebounded more sharply than the less volatile surplus countries. Indeed, 10-year USD Indonesian government debt (which declined by 14.2% during June- August) has returned roughly 14.5% during the last two months. Meanwhile, AA-rated South Korea 10-year debt has returned only 2.6% in the same period (Fig. 2). Figure 2: Dual-deficit EM debt returns have been more volatile Source: The Yield Book.. While core interest rates are likely to remain supportive for EM assets near term, our analysts remain wary about return prospects as we approach 2014. In their view, the strong recent performance provides EM investors with a window of opportunity to reposition portfolios and become more discriminating about duration and credit exposures. Once Fed tapering inevitably begins, core rates will rise and a withdrawal of liquidity from EM markets will resume. Prevailing fiscal pressures and current account deficits will exacerbate deteriorating fundamentals, accompanied by weaker currencies and wider spreads, in our analysts view. Thus, Citi analysts remain underweight EM debt in both balanced and all fixed-income portfolios. EM corporate debt gained more than 2.0% in October. While spreads have compressed, issuers remain attractive relative to similarly-rated credits in the developed markets. While the rally may persist near term, our analysts recommend investors focus on short duration opportunities, limit exposure to high quality credits, and to pare portfolio positions in marginal issuers. Investment Grade Corporate Bonds Global high grade corporate debt continued to benefit from the delay in Fed tapering, which triggered lower government rates and an increase in risk appetites. Long-dated and low-quality issuers clearly outperformed as investors flocked to the higher-beta (higher yielding) credits that sold off during the summer months (Fig. 3). US and European corporate markets rose by more than 1.0% in October (year-to-date total returns are now -1.5% and 2.6%, respectively). Index yields tracked the recent decline in core rates, while spreads narrowed by about 10bp to 12bp. High grade spreads currently hover near post-crisis lows (around 130bp). In the near term, rangebound rates and improved financial conditions should be beneficial for credit. While technical support from fund flows has weakened, fundamentals remain encouraging. Concerns about debt leverage in non-financial credits appears warranted, though cash levels remain high, interest expense has declined, and refinancing risks are more diluted. Beyond the immediate term, the threat of higher interest rates (not credit quality) remains our analysts principal concern for high grade returns, particularly in the US and UK. Citi analysts continue to favour defensive duration exposure (3-7 years) and financials over non-financial debt (with a focus on US and core EU bank / insurance issuers).
High Yield Corporate Bonds Impressive gains in high yield continued. US and European high yield debt returns have exceeded 6.0% and 8.0% this year, respectively, supported by lower core rates and strong risk appetites. HY spreads in both regions have approached post-recession lows as index yields grind lower. Indeed, European HY issuer yields declined to a historic low of 5.35% on October 31. Floating rate bank loans have also rallied, but are lagging fixed-rate securities with a 4.5% total return YTD. Citi analysts maintain a constructive view on the HY sector. Mutual fund inflows have strengthened the technical backdrop and credit fundamentals remain relatively strong. Indeed, Moody s US speculative grade default rate declined to 2.6% at the end of the third quarter compared to 3.7% one year ago (the bank loan default rate is 2.5%) (Fig.4). In the current climate which should persist through year-end lower-quality credits are poised to outperform. However, the gradual rise in long-term rates that we expect in 2014 will prove to be more challenging for high yield returns. Figure 3: Long duration/low quality corps have outperformed Source: The Yield Book Figure 4: Low HY default rates reflect still-solid fundamentals Source: Moody s, The Yield Book In Citi analysts view, potential rate risks far exceed current credit risks. Thus, they encourage HY investors to minimize long duration exposures. While fixed-rate debt will likely outperform floating-rate loans in the near term, the resumption of rising rate concerns will boost bank loan performance next year.