There is no doubt that global markets have provided some inclement conditions. To date, 2010 has been a challenging investment environment, characterised by many conflicting signals as to whether the global economic recovery has begun to take root or not.
The enormous stimulus provided by the authorities in 2009 helped lead to signs of a recovery in 2009 and early 2010, causing riskier assets to rally sharply. However, this was interrupted when the European sovereign debt crisis started to hit in March.
Recent press coverage has led to discussion about the emergence of a bond bubble – but there are flaws in this argument.
We do not deny that certain areas of the market may be a little overvalued at present but we maintain that inflationary pressures in Europe and the US are likely to abate, especially given the backdrop of high unemployment and low growth.
Taking such considerations into account, we believe that bonds start to look much less overvalued.
All in all, therefore, we would argue that talk of a bond bubble is nonsense when you consider their intrinsic value. That said, our tendency at the moment is to be relatively cautious as we want to avoid exposing investors in the fund to undue credit risks.
Due to renewed risk aversion in the markets, the most significant change to the portfolio in recent months has been at sector allocation level.
At the end of 2009, we were overweight high-yield credit and emerging market debt. As market volatility increased we began to reduce our risk exposure, meaning that by the end of the second quarter of 2010 we had a roughly neutral exposure to corporate bonds.
The fund’s emerging markets debt exposure has been reduced and, as elsewhere, holdings in this area reflect the team’s broad preference for higher-quality sovereign issues. The fund therefore maintains exposure to Brazilian bonds, while an earlier position in Hungarian government debt was cut before yields subsequently spiked.
Furthermore, consistent with the decision to reduce the overall level of risk in the fund, within the credit portion, exposure is pretty well diversified between issuers and sectors.
Specifically, the fund does not own any tier-one bank bonds, as previous holdings were sold as part of the risk-reduction effort. Our preferred credit holdings within the financial sector include issues by BNP Paribas, Société Générale, Citigroup, Barclays and JP Morgan – so, predominantly well capitalised, global banks.
Our low exposure to peripheral sovereign bond markets was a significant boon for relative performance in the period following the Greek debt crisis.
The fund’s allocations in this area have been fairly flexible and overweight positions in Spanish and Italian government bonds (subsequently reduced and sold, respectively) during the risk rally in July 2010 were, in fact, strongly beneficial to returns.
We have studiously avoided Portuguese and Irish debt as these are smaller economies with big problems.
Conversely, it should be emphasised that we do not have significant concerns about the sovereign creditworthiness of Spain or Italy and these bonds offer an attractive opportunity to pick up extra yield over German bunds.
We believe these spreads are probably higher than they really should be. Ultimately, this will depend on individuals’ assessments of the credit risks posed by these bonds.
David Leduc is manager of the BNY Mellon global strategic bond fund