What next in the Bond Market?
While the markets are now optimistic about risk, the realities of the world economy still do not justify unbridled optimism, given this scenario it may be prudent to invest in government debt on any dip

By Matein Khalid

It is now self evident to even the most diehard equity bull that investors, since they cannot foretell, the future, must diversify their portfolios among diverse asset classes. After all, in the past decade, the ten-year US Treasury bond and even the humble GCC banks cash deposit has grossly outperformed the SP500 index. Bonds are a natural hedge against systematic financial risk and a stock market freefall, as the world learnt during the successive Wall Street panics of 2008. This business cycle is unlike anything the world has seen since the 1980’s. More than six million Americans are unemployed and the jobless rate is 8.5 per cent. Some of US and Britain’s mightiest banks are on government life support. Credit risk is priced higher than at anytime since the Great Depression. The Fed’s inflation phobia in summer 2008 (when oil hit $147) has turned to deflation hysteria.

Central banks have scrambled to slash short term borrowing rates to near zero in the US, Canada, Britain, Japan and Switzerland. However, the fiscal and monetary response to the credit crisis in the US has been monumental, with a $2 trn budget deficit and a Federal Reserve that has doubled the size of its balance sheet. The Fed’s role as the lender, issuer and guarantor of the last resort to the banking system and the seismic changes in the landscape of Wall Street investment banking have changed the rules of the game in the bond market. The brave new world of the debt investing offers both exceptional opportunities and very real risks.

Best case scenario
Conventional wisdom suggests that investing in bonds amid a period of epic central banks money printing is the height of folly. However, it is impossible to envisage the runaway inflation of the 1970’s (the kiss of debt for world debt markets) any time in the near future as long as the US economy remains fragile and sluggish bank credit growth dampens the money multiplier. Inflation will trend lower, the US economy will not deliver positive GDP growth until next spring and the Federal Reserve will do its best to buy long dated US Treasury bonds (classic quant easing, as spelled out in the March, Federal Open Market Committee (FOMC)) whenever the yield on the bellwether 10-year note crosses 3.20 per cent. I still believe the yields of Uncle Sam’s IOU (debt) will drift lower in the months ahead and must remain a nervous long in the US Treasury bond market.

The German bond market, I feel, offers far better value at a time when the export economy has tanked and Berlin forecasts a shocking six per cent GDP plunge in 2009. The European Central Bank (ECB), in any case, will reduce its refinance rate even below one percent, a tacit admission of quant easing and the purchase of German government debt by Jean-Claude Trichet’s (President of ECB) gnomes is no longer unthinkable. In any case, quant easing suggests that volatility in the interest rate markets will fall and yield curves will flatten, with the two- ten US Treasury yield curve flattening from the current 240 to as low as 150 basis points. Despite their 1.4 percent yield, Japanese government bonds are not expensive, though I doubt if there is any real return upside in Asia’s stricken export tiger.

Cash will be a loser’s game, unless investors are tempted by the high credit risk bank deposit returns offered by Gulf banks. The FOMC cannot and will not tighten monetary policy for at least the next eight months as long as the monthly jobless rate keeps rising, house prices do not bottom and the uncertainty over stress tests on US banks capital is unresolved. Therefore, it is all too likely that the Fed Funds rate will remain in its current 0-25 basis point range until at least summer 2010. The Bundesbank’s Weimar Republic obsessions will restrain any move to unconventional easing by the ECB, though it is entirely possible that the next cut in the repo rate will not be the last. Cash returns in the US and Eurozone money markets will be a derisory 1- 1.5 per cent.

Value buys
The US corporate debt market offers exceptional value at current levels, despite sluggish profits, downgrade risks and mark to market woes amid global recession. However, I believe that the risk rally in speculative high yield junk bonds has been overdone and investors should rotate into the quality, investment grade segment of the corporate bond market, ideally AA blue chips. British industrial corporates will clearly benefit from Governor King’s determination to revive economic growth via direct Bank of England purchases of British corporate debt. Sure, credit downgrades will widen credit spreads, financials still face a credit Black Death in their loan books and default risk is far too high in UK or European leveraged loan or high yield debt markets.

It is therefore best to remain invested in high grade investment debt in both the US and Europe. In the Gulf, I believe Mubadala’s ten year dollar bonds offer deep value at eight per cent for a AA rated Abu Dhabi sovereign wealth fund whose business model clearly positions it as the Gulf’s Temasek. Abu Dhabi Government bonds were a winner as spreads tightened by 100 basis points and I would not be surprised to see Mubadala five– ten year note yields compress as regional banks and insurance companies scramble to buy Abu Dhabi sovereign risk at spreads more normally associated with bank loans in the Gulf.

I believe it makes no sense to overweight commodity linked debt at current levels. Oil prices can fall below $45 as US inventories are the highest since the 1990’s, the swine flu scare will prove a disaster for the jet fuel market and Saudi Arabia does not succeed in boosting compliance from quota overproducers like Iran, Venezuela, Angola and Nigeria in OPEC. IMF gold selling and reduction in systematic risk can dampen gold prices to $800. Copper is an accident waiting to happen as Chinese do not add reserves at $4200 per tonne London Metal Exchange (LME) prices. This is not bullish for the debt of Big Oil, Freeport Mc Moran or Newport Mining. While the markets are now optimistic about risk, the realities of the world economy still do not justify unbridled optimism. It is still prudent to invest in government debt on any dip.

The author is a renowned investment banker based in Dubai

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