Bond market’s rally warrants skepticism
Investors have responded enthusiastically in recent months to government stimulus plans and signs of renewed economic activity, triggering a resounding risk rally.
Investors have responded enthusiastically in recent months to government stimulus plans and signs of renewed economic activity, triggering a resounding risk rally.
Since March 9, the U.S. stock and corporate-high-yield-bond markets have enjoyed a rebound. High-yield bonds clearly have been the top- performing segment of the U.S. bond market so far this year.
What has driven this “dash to trash?”
Although there have been signs of economic stabilization, we think that the recent market move has been mostly technical in nature. Some of it has been due to the prevalent low-yield environment.
As short-term Treasury yields have dropped below 1% and longer-term Treasury yields have remained in the 3%-4% range, fixed-income investors have been actively seeking higher-yielding alternatives.
Some of it has been value- seeking contrarianism. When yield differences between similar-maturity Treasury and high-yield corporate bonds soared to record levels at the end of last year, investors viewed the wider spreads as a buying opportunity in the high-yield market.
Finally, some of the new vigor is a result of the traditional discounting mechanism of the markets. The stock and high-yield-bond markets tend to incorporate and price economic conditions expected six to 12 months ahead.
Those expectations turned positive in recent months because of the unprecedented level of economic and credit market stimulus provided by governments and central banks around the world. Invest-ors also saw signs that the housing market might be bottoming, the credit markets stabilizing and the worst of the layoffs in the U.S. labor market ending.
Despite signs of a turning point, our fixed-income team remains skeptical. Although markets appear priced for a rapid V-shaped recovery, we think that the U.S. economy remains mired in a consumer-led Great Recession that will end with a slow L-shaped pattern of recovery.
We see this economic downturn as consumer- and credit-driven. Although government bailouts have improved liquidity and confidence in the financial sector, the real economy continues to struggle.
We think the core causes of this recession can be traced back to the bursting housing and credit bubbles. Therefore, we still believe strongly that the ultimate springboard for economic recovery will be housing price stability, improved availability of consumer credit and a strong, sustained rebound in consumer demand and spending.
We aren’t there yet. We see potential for further declines in home prices because of rising mortgage defaults and foreclosures, which will erode consumer confidence and spending as the employment situation worsens.
Meanwhile, mortgage interest rates have come down from 2007-08 levels, but qualifying for those rates and actually obtaining loans from financially stressed lenders remains challenging.
We have identified and evaluated a number of other critical factors that we think will determine bond market performance.
Some indicate better risk-taking conditions, but others still signal poor risk-taking conditions.
These include slowing global economic growth, inoperative securitization markets and our expectation that corporate default rates will accelerate significantly this year.
STILL NEGATIVE
In our view, the negative factors still outweigh the positive.
We think hopes for a sizable economic rebound in the second half of the year are overly optimistic.
As a result, we think it is still early to be pursuing credit risk aggressively. Instead, we are still bullish on investment-grade bonds outside nominal/traditional Treasuries.
Our choices include inflation-indexed securities, investment-grade non-general-obligation municipals, government-sponsored/guaranteed mortgage-backed securities and high-quality bonds of major corporations.
We are adding exposure in the corporate sector, but we are moving carefully and selectively.
During the past two years, we have experienced historic levels of turbulence as the bursting credit bubble has generated huge waves of re-pricing in the credit markets.
We think volatility and a wide range of bond returns will persist this year, though we think that the dispersion will migrate largely from broad sectors to individual securities.
G. David MacEwen is chief investment officer of fixed income for American Century Investments of Kansas City, Mo. He is based in the company’s Mountain View, Calif., office.
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