George Muzinich calls investor behaviour ‘blinkered

Where is the ‘quality’ in the UK and US government bonds in which investors are seeking sanctuary, asks George Muzinich of fixed income manager Muzinich & Co.

For the first time in its history the United States has been stripped by a major ratings agency of its AAA rating. On August 2nd, after political brinkmanship that delayed the authorisation of an increase in its debt ceiling, the US was narrowly spared the humiliation of temporarily not being able to meet its debt obligations.

This provided scant relief to the financial markets as economic data was released that showed the US economy was in considerably worse shape than originally believed. All of a sudden, the belated realisation that the US may be in a stagnant, no-growth environment hit the financial markets. The US avoided technical default by the passage of its August 2nd legislation. The solution to the mini-crisis was again a weak political compromise that begged more questions about the future of the country’s economy.

Italy and Spain, the Eurozone’s third and fourth largest economies, are suffering from low growth and high debt levels. They have seen their funding costs rise dramatically to levels that are unsustainable.

Recent European financial initiatives to stabilise Greece’s solvency drama hardly provided any answers. They only succeeded in raising more questions about the future of the Euro. The housing and banking crisis of 2008/2009 is now becoming the sovereign debt crisis of 2011. Since political and regulatory pressures have pushed banks to hold sovereign debt which was classified as “risk free”, we again have a banking crisis.

Two worlds

At the same time, the US Commerce Department last week revised upwards its estimates of US corporate profits by 8.3% for 2009 and 10.8% for 2010.

Corporate profits in the US hit a new record of 14% of GDP in 2010, nicely surpassing the previous high point of 13.6% set in 1942 during the war time rearmament rush. The Commerce Department estimated that profits in the first quarter of 2011 continued to climb and hit a new all-time high of 14.2% of GDP, considerably higher than an earlier estimate of 13.1%.

We are dealing in two different worlds. One is a heavily indebted world of deteriorating sovereign debt. The other is a profit-generating world of strong corporate balance sheets. The two worlds cannot continue to drift apart forever. Hopefully, the marketplace discipline of the corporate sector will gradually become a standard that the public sector cannot ignore.

Flight to quality? What quality?

Last week witnessed a flight to supposed “quality”. The yield on the US 10-year bond went below 2.39% from 3.74% six months ago. The 10-year UK gilt hit a record low yield of 2.68%. Looking at both countries’ financial fundamentals one has to question what kind of “quality” an investor is buying.

Our universe of better quality BB/B credits has suffered some modest price deterioration from some investors’ knee-jerk reactions to reduce supposed “risk” from their portfolios. There were no negative developments on the corporate bond front but August volatility increased due to banks’ limited willingness to make markets, the greater market presence of volatile ETFs and a relative lack of market participants due to the August vacation period.

Spreads in the BB/B universe are now approaching 600 basis points. Over the past 10 years we have seen spreads trade over 600 basis points for any three-month period on only two occasions: the period between July 2002 and April 2003 and the period between September 2008 and September 2009. Current high yield market levels assume a default rate of 6.6%, which is in sharp contrast to widely expected broad market default rates of 2% or less for the next two years. It is worth noting that our flagship Americayield Fund has experienced only one default in the past eight years.

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