March 2013 Some investors rushed to hedge bond portfolios - as interest rates rose at the start of the year. In recent weeks, however, yields declined across the major markets, reminding investors that the path to higher rates will not be linear. Indeed, core rates are likely to be rangebound near term as Italian election uncertainties, mixed economic data, and the US fiscal debate weigh heavily on the yield curve. Recent downtick in bond yields - is likely to be transitory. As uncertainties dissipate, rates will seek higher ground later this year to reflect lower tail risks and improving growth prospects, particularly in the US. In the UK, a weak sterling coupled with rising inflation should put upward pressure on Gilt yields. Recession, political instability and two more ECB rate cuts this year should anchor Bunds around current levels. Citi analysts remain underweight core developed sovereign debt - and continue to favour corporate and emerging market bonds. Possible currency intervention by central banks is likely to be the major driver of returns in local emerging market debt. 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 Outperform Market Perform Outperform Remain underweight; Favour short-duration due to risk of rising rates; US & UK to underperform Germany & Japan ECB backstop dilutes tail risks but fiscal challenges remain; Expect Italy election concerns to heighten volatility near term Remain overweight hard currency and local EM markets; FX intervention by central banks is likely to be the major driver of returns in local bond markets; Our analysts favour Mexico and Russia Slight overweight. Despite low absolute yields, carry is still attractive; Focus on US financials and subordinated debt Despite historically low yields and less attractive valuations, risk-on momentum likely to drive spreads tighter *EU Periphery Sovereigns include bonds from countries such as Greece, Ireland, Italy, Portugal and Spain.
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Developed Markets Government Bonds Interest rates declined across the major markets in recent weeks. Indeed, 10-year US Treasury yields have declined by approximately 22 basis points (bp) since reaching a 10-month high of 2.02% on February 13. Ten-year German Bunds have fallen by about 30bp from recent highs, and are now testing their lows for the year (Fig. 1). Both markets have benefitted from economic concerns and uncertainty premiums that are fuelling flight-to-quality demand for these assets. This should come as no surprise to bond investors. Indeed, as we relayed to our readers when yields were backing up in January, it seemed too early to call for a structural bear market in bonds. In short, our analysts did not believe that the early-year selloff would stick given all the near-term uncertainty that prevailed in Europe and the US Figure 1: Upward bias to sovereign rates temporarily reversed Figure 2: Bunds likely to outperform other major govt markets Source: The Yield Book. Source: Citi Global Economic Outlook and Strategy February 27, 2013 All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. In the near term, benchmark rates are likely to remain rangebound as sluggish growth prospects, Italian election uncertainties, and the US fiscal debate weigh heavily on the yield curve. These factors -- along with benign inflation pressures -- are likely to cap any substantial backup in bond yields in coming months. That said, our analysts expect the current downtick in bond yields to be transitory. As uncertainties are resolved, interest rates will naturally seek higher ground to reflect lower tail risks and improving growth prospects (particularly in the US and Japan) during the second half of this year. Japan should benefit from a weaker yen and more aggressive government stimulus, while a recovering housing market and less private sector deleveraging will bolster activity in the US. In the UK, a weak sterling coupled with rising inflation should create upward pressure on Gilt yields, in our analysts view. This should drive the 10-year benchmark to around 2.4% by the end of the year, only a shade lower than the 2.6% projection our analysts have for 10-year Treasury yields. While it has little bearing on their rate view, it's worth mentioning that UK sovereign debt was downgraded by Moody's on February 22. Citi analysts expect the other rating agencies to follow suit this year. Meanwhile, the EMU will remain mired in recession and facing increasingly difficult choices about the periphery. Against this backdrop, German bunds are likely to outperform other major sovereign markets (Fig. 2). The front end of the curve should be well-supported by two 25bp rate cuts from the ECB during the next 6 months, in our analysts view. Deteriorating growth and political instability should also anchor long-dated Bund yields around current levels. Overall, Citi analysts remain underweight developed sovereign debt (they prefer to maintain fixed income exposures in credit markets and EM), and are particularly wary of longer-dated maturities. They generally expect developed market yield curves to bear steepen as long rates rise and accommodative central bank policies anchor front-end maturities.
Emerging Markets Government Bonds Hard currency (US dollar-denominated) sovereign yields have risen to a four-month high (4.25%) after reaching historic low in early January (Fig. 3). Investors have been taking profits recently, reaping the benefits of the doubledigit returns it generated last year. Investors appear to be placing more focus on corporate debt and local currency markets (debt and equity), which feature more attractive yield opportunities. So far this year, hard currency sovereigns have declined by about 1.3%, underperforming most US credit markets. While pressures on the sector may persist near term, our analysts continue to expect EM dollar-denominated debt to outperform the broad market this year. Local EM sovereign debt has fared better than external debt. Bond yields have generally been rangebound this year (Fig. 4). Investors seem somewhat cautious given the uncertainties about "currency wars" being played out in the larger developed markets. In our analysts view, local bond markets will continue to benefit from slower growth (albeit much higher than the developed markets), benign inflation pressures and more dovish central banks. Idiosyncratic factors (i.e., politics, food inflation) are likely to drive performance amongst these fast-developing countries, including the direction of the local currency. The possibility of FX intervention by central banks is likely to be the major driver of returns in local bond markets. The tolerance for currency manipulation is dependent on each country s own economic backdrop, as well as each central banks own appetite for quantitative measures. As a result, there will be considerable inconsistency across the entire emerging market space on a central banks willingness to intervene. Figure 3: Hard currency yields have risen from historic lows Source: The Yield Book. Figure 4: Local government bond yields have been rangebound Source: JP Morgan In Latin America, we have lately been focused on Mexico, where a rate cut appears likely, in our view. As we highlighted last month, central bank minutes from Banxico's January 18 meeting reflected a dovish tone. With inflation becoming less of a concern (Citi economists lowered their inflation forecast for Mexico this month), and growth showing signs of stabilizing, it's likely we will see a 50bp rate cut by year-end. Mexico Bonos remains one of our favorite local currency markets. In Asia, our analysts back off their favorable view on Indonesian local debt. After rallying 100 basis points since August 2012, 10-year bonds now yield 5.25%, near historic lows. With signs of inflation pressures and improving growth prospects, the odds for policy rate hikes have increased. In CEEMA, the beginning of direct settlement of Russian sovereign debt (and soon Russian corporate debt) through Euroclear has provided a strong bid to the market. Citi analysts believe there is still room to appreciate and find the short-end of the Russian OFZ curve attractive. 3-year OFZ bonds trade near 6%. a
Investment Grade Corporate Bonds As we move toward the end of the first quarter, high grade corporate debt returns overall are barely positive. Global credit spreads are slightly wider overall, led by Europe, as increasing political risks (i.e., Italy, Cyprus) have dampened risk appetite. On the other hand, US corporate spreads have been more resilient, barely moving 1-2 basis points during the last eight weeks (Fig. 5). This is due to a more favorable backdrop for economic activity despite near term political risks (i.e., sequestration, continuing resolution). Figure 5: US corporate spreads have been more resilient Source: The Yield Book. Spread movements (or lack thereof) have been overshadowed by the volatility in core developed sovereign debt. Yields in the largest developed markets broadly moved to a higher range until surprising Italian election results and concerns over the US sequestration sharply halted the trend. Although the near-term direction in interest rates is likely to be dictated by political uncertainties, our analysts expect growth prospects will continue to improve (ex-europe). This should drive corporate bond spreads tighter relative to current levels. That said, our analysts do not expect the progression to be linear, and returns are likely to be very modest. Indeed, in high grade, investors should expect only low single digit returns this year compared to the impressive double-digit returns of the last several years. bsolute yields as a percentage of risk-free rates are high (Fig. 5). -yield issuers) are expected to be In this climate, credit selection will be paramount to identify scarce relative value. But investor focus should also be squarely placed on duration. Given our analysts expectations for modestly higher interest rates (particularly in the US and UK) and steeper yield curves later this year, they recommend investors favour intermediate term maturities (5-10 years) where carry and roll down features remain attractive. Citi analysts recommend Triple-B credits, where recent underperformance has been driven by LBO activity among a select few issuers. In their view, wider spreads and relatively attractive yields fairly compensate investors for the potential rise in risk-free rates. Our analysts continue to favour US issuers over European credits as periphery concerns re-emerge and growth prospects for the two economies diverge. They also still favour the US bank and finance sector, which has outperformed non-financials by nearly 100bp year-to-date (Fig. 6). The metals/mining sector is attractive and should perform well as the global economic heals. Telecom and media credits feature decent value given their conservative balance sheets and recurring revenue streams. Figure 6: Financials have outperformed industrials YTD Source: The Yield Book.
High Yield Corporate Bonds High yield corporates have been one of the best performing markets in fixed income. This is especially notable in the US, where high yield debt has gained nearly 2.0% this year (or 12% during the last 12 months). At this rate, the market is well on its way to outpace the 6.0% to 7.0% total returns our analysts projected for this year. Positive economic momentum and easy monetary policy should continue to support risk assets. Current spreads are only about 30bp above five-year lows. Yet, they remain 235bp higher than the lows reached in 2007. Although spreads are unlikely to tighten to 07 levels (considering that absolute yields are near historical lows), spreads are likely to decline further this year. This is supported by current default rates, which remain very low relative to long-term norms (Fig. 7). Indeed, Moody.s global speculative default rate declined to 2.5% (defaults historically trend greater than 4.0%). Citi analysts expect the strong appetite for yield to easily absorb a robust new supply calendar, especially in loans. Figure 7: The high yield default rate remains low Source: Moodys. In our analysts view, both bank loans and high yield debt offer value. Average yields and spreads in both markets are comparable (about a 5.9% yield and around 500bp spread). While they expect both structures to perform well, Citi analysts favour the floating rate component in leveraged loans. Investors may prefer a floating rate instrument if they believe, as our analysts do, that higher US rates are likely to transpire later this year. For senior unsecured buyers, there is still value in Single- B issuers. While yields dropped below 6.0% (currently 5.8%), our analysts continue to believe that these offer attractive carry and better return prospects compared to Double-B rated issuers.