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Credit check

Graham Glass, lead manager of the City Financial strategic global bond fund, on how to stave off the twin threats of a government bond bubble and credit market illiquidity

Once again, fixed-income markets are facing a great deal of uncertainty.

Within the government bond sector, this can be split into two main classes, peripheral Europe and safe-haven bonds.

As investors become increasingly concerned with events in peripheral Europe, risk assets have been sold off. Spanish 10-year yields are running at 6.07 per cent while Italian yields have also widened and the 10-year benchmark is now just below 5.63 per cent.

Meanwhile, demand for bonds issued by the US, UK and German governments has soared, driving yields to what many perceive as artificially low levels.

The question remains, when will the so-called bubble of government bonds burst? Mid-March saw a return to relative normality, with relief following the European Central Bank’s refinancing action boosting risk markets.

An increase of 30-40 basis points was seen in US, UK and German government bonds, breaking a one-year trend of declining yields. The government bond bears were out in force, with talk of rising short-term rates and many strategic bond fund managers positioning themselves against interest-rate risk.

Concerns about peripheral Europe saw a sharp sell-off in government markets in March, followed by a sustained rally in risk-free assets.

The market’s focus was on Spain as rating agency S&P downgraded the sovereign rating from A to BBB+ on March 26, and Moody’s slashed the credit rating on 16 Spanish banks on May 17.

Credit markets, as one would expect in this flight- to-quality environment, are underperforming the broad government indices. That is why we have chosen to concentrate holdings into issuers that exhibit strong fundamentals and those that show a lengthy period of positive free cashflow and a well distributed debt curve, such as HSBC, Standard Chartered and Barclays.

One aspect against which we are rigorously defending is the evaporation of market liquidity. A simple observation is that the available capital for credit bond traders at investment banks has been dramatically reduced during the past five years.

Proprietary trading desks have historically been one of the providers of liquidity to markets but they are now a dying breed due to the implications of the Volcker rule and Basel III requirements.

It is estimated that the corporate bond inventory has fallen to a nine-year low. According to the Federal Reserve, inventories of US corporate bonds stand at just $45bn. During February 2011, that figure was $93bn while $135bn was reported in February 2006.

The impact on the tradability of credit bonds is also significant as they trade by negotiation. There is no centralised price and deals are executed in the market by trading desks of major investment houses who want to facilitate the trade. A method of analysing market liquidity is monitoring the percent- age difference between the bid and offer prices of bonds.

The solutions to this are relatively straightforward and we are positioned to protect against a lack of liquidity in underlying instruments in the following ways:

  • Strict diversification guidelines for holdings within the fund, with credit positions being limited to 5 per cent of the value of the fund at issuer level.
  • Holding top-quality issues with a large amount of bonds outstanding.
  • Using the fund size to obtain trading prices from the investment banks.
  • Avoiding overtrading in the choppy market.

The past four years have seen investors focus on fixed- income markets as a leading indicator of how risk markets will fare in general. We anticipate this to continue over the coming months with geopolitical newsflow driving investor appetite not only for credit but also for equities over the traditionally volatile summer period.


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