Despite the significant gains generated in bond markets in 2009, we believe the case for corporate bonds remains strong.
Their valuations remain attractive by historical standards, credit fundamentals remained relatively robust during the crisis and are now improving and the global economy is recovering. However, we believe valuations are no longer compelling across the board and issue selection and sub-sector rotation are becoming increasingly important.
Economic data continues to signal improving conditions and we would not be surprised to see a few quarters of above-average growth in the first half of 2010, particularly in the US, but we remain suspicious about the durability of the recovery past 2010. Despite this cautious outlook, we continue to hold a preference for non-government bond markets, in particular corporate bonds.
Both investment grade and high yield corporate bond valuations still imply higher default rates than we think will materialise. Indeed, in the US high yield market, default rates peaked in late 2009 and have already started to come down. As default rates recede, corporate bonds should continue to perform relatively well, at a minimum outperforming government bonds. Should the economic recovery gain a degree of durability, pricing on risky assets could rise further. In addition, credit fundamentals, such as corporate leverage and liquidity levels, should continue to improve.
Following the broad-based bond market gains in 2009, investors have started to differentiate more between bond issuers. Issue selection and subsector rotation will therefore be key to positive returns in the next phase of the bond market recovery.
In investment grade corporate bonds, we believe the industrial and utility sectors look less attractive than financial issues.
While we recognise the recent bank reform proposals announced in the US and related discussions across Europe have added considerable uncertainty to the future of the banking sector, we believe tighter regulation should be viewed as inevitable, logical and generally bond-holder friendly.
In the high-yield sector, we are seeing opportunities in BB-rated bonds, in particular those securities we believe have a reasonable chance of being upgraded to investment grade within the next year.
Active interest rate duration management will also remain important to generate positive total returns in credit funds. We expect heightened volatility in government bond yields on the back of uncertainty over the outlook for inflation, the timing of potential interest rates hikes by central banks and fears of increased supply.
Dipankar Shewaram is portfolio manager at Western Asset Management, an affiliate of Legg Mason
