Bond Outlook by bridport & cie, December 1st 2010

If you can keep your head when all about you are losing theirs...

A little advice from Kipling may be opportune for investors at this time of fears about EUR sovereign debt, and it is certainly appropriate for those, like Trichet, on whom the responsibility of reassuring markets falls. Only the ECB has the depth of capital sufficient to stop the haemorrhaging of confidence in the debt of profligate countries. Our view remains unchanged: the political will within the EMU is strong enough (for the present) to ensure a solution in the immediate future. That does not mean that the situation will not worsen before it gets better. Neither does it mean that there will not be a major change in the structure or the workings of the euro zone in time.

It happens that the fear of EUR sovereign default has coincided with that period of the year when market makers seek to empty their books and decline to make real bids (as distinct from their phoney prices on screens). The contagion has spread to many corporate issues. This has brought an abrupt end to the recent spree of new corporate issues, and made it very difficult to sell existing bonds at realistic prices. In fact, we go so far as to say that this is not the time to sell, as prices are too low and unstable. On the contrary, this is a time to buy. For several months we have been recommending larger than usual cash holdings – actually because we expect yield curve steepening. Our recommendation is to take advantage of discounted prices modestly to expand holdings of selected corporate bonds.

As we suggested in a recent Weekly, there are even opportunities in euro zone sovereigns, but only for those accepting the risk.

In the context of expected success in the short-term bail-out but a long-term revamp of the EMU, a few comments seen appropriate:

• the choice for the EMU is stark: break up or much greater centralised control
• it is not so unthinkable to redenominate government bonds in a legacy or new currency
• it may be unfortunate that the bail-out of Ireland is focused on lending to banks and has only become a sovereign bail-out because of a full guarantee of bank debt by the Irish State
• a major advantage of many countries to join the euro zone was that they would benefit from German-like interest rates. That led to the housing bubbles and bloated government spending which are the cause of the current crisis
• since interest rates for profligate countries are no longer low, the attraction of staying in the EMU is much reduced
• so long as the euro zone is in the bail-out mode, the ECB will be buying both sovereign and (possibly) bank bonds. However, the ECB claims this is not quantitative easing as equivalent liquidities are removed from the banking system (neutralisation). This can only mean slower growth

The problems of the euro zone have taken most eyes off the USA. There are some modest signs of economic improvement – T-Bonds should be sold as the yield curve steepens – but the problem of house prices remains chronic. Case and Shiller see a further average fall of 10% in housing prices, with no chance of a turn-around until foreclosed properties are sold off or removed from the market. There is a debate as to whether foreclosures should be hastened in order to reach a price bottom more quickly. That might not be so easy while the issues of legal title are still unresolved.

Focus

• USA: consumer confidence rose to a five month high in November. The ISM Chicago’s business barometer rose to 62.5 from 60.6. Jobless claims declined by 34,000 to 407,000, the lowest level since July 2008
• UK: the Office for Budget Responsibility cut its 2011 growth forecast to 2.1 % from 2.3% and said the economy will expand 2.6% in 2012 instead of 2.8%. Export growth is helping the economic recovery
• Europe: Confidence in the economic outlook improved to the highest in three years in November. An index of executive and consumer sentiment in the 16 euro nations rose to 105.3 from 103.8. Senior bondholders will not be compelled to pay some of the cost of rescuing Ireland's banks under the EU/IMF bailout, with the ECB effectively vetoing any such move
• Spain: the start of its EUR 13.5 billion-euro programme to sell state-guaranteed power revenue bonds was frozen until government debt-market volatility abates
• Germany: a levy on German banks to set up a EUR 70 billion fund for future bailouts was approved in parliament. The measure aims to reduce the risk of taxpayers footing the bill for financial crises
• Russia: the central bank retracted a pledge to keep its main interest rate at a record low 7.75%. “for the coming months,” prompting analysts to predict a raise in the near term
• Worldwide: corporate bond Issuance has slumped 31 % since November 15th, compared with the same period a year earlier, after surging 34 % in the first half of the month

Recommended average maturity for bonds (corporate/government)

Extend the barbell in corporate bonds from EUR to include USD (cash/7years).