Credit markets have staged an exceptional rally in recent months. The US corporate bond market, for instance, registered record relative returns compared to US Treasuries in April and May (based on the Barclays Capital US Credit Bond Index).
The improving economic outlook and reduced concerns over the recapitalisation needs of financial institutions boosted investor confidence. Indeed, investors were encouraged by the size and scale of governments’ and central banks’ policy action around the globe, leading them to reassess their pessimistic outlook on corporate defaults and the wider economy.
Stabilising economic activity and improving lending activity are now encouraging one another. Although we continue to see forceful headwinds for consumer spending, we believe economic activity should continue to stabilise and resume positive growth in the near term, even if at a subdued pace. However, we do consider the current recovery fragile and believe central bankers should remain vigilant of further slippage. While much has been made about the inflationary impact of the major central banks’ quantitative easing, we expect a continued easing in pricing pressures (disinflation), as most major economies are still operating below capacity and resources remain under-utilised.
During the crisis, investors fled for the safety of money market funds and government bonds. However, with money market investments now generating meagre returns, cash is slowly being redeployed in the credit market, helping to support valuations. We have been pleasantly surprised by the strength of the credit market recovery over the past few months. We had expected pricing to converge towards fundamental values at a slower pace and are pleased to see market prices rising towards what we had long felt are more accurate valuations. We have long held the belief that investors had overstated the risk of corporate defaults in bond valuations. Despite the recent strong performance, however, we believe most non-government sectors still have ample room for improvement and are likely to outperform government bonds over the remainder of 2009 and possibly beyond.
Within the non-government sectors, we have cut back our exposure to agency mortgage-backed securities in favour of investment-grade corporate bonds. Despite support for the former sector from the Fed’s ongoing purchase programme, we feel that the attractiveness of the asset class relative to other sectors has faded. Meanwhile, valuations in both investment-grade and high-yield corporate debt continue to be attractive as they continue to overstate default risks.
Mike Zelouf is product specialist at Western Asset Management (an affiliate of Legg Mason)
