Phil Milburn (pictured), fixed income manager at Kames Capital, says in a note that the sovereign crisis could get worse before it gets better, but that with bad news priced into corporate bonds already the time to buy is approaching.
The Kames Strategic Global Bond Fund had a poor August returning -2.43%, compared to the 0.40% Lipper median.* This result hides a lot of the good work we did to mitigate the impact of one of the worst months for credit on record. The positive aspects included aggressively adding duration risk to the Fund, the use of credit default swap index hedges to reduce credit beta and, importantly, avoiding the biggest losers, particularly with regard to high yield. Thankfully, even though we liked the asset class, we have had a more conservative weighting toward high yield bonds than some of our competitors (we explicitly did not want the risk to dominate the Fund). This is one of the main reasons why the Fund retains a positive absolute return year-to-date, ending August at 2.06%.
The impact of the S&P downgrade to the US credit rating might have affected market perceptions of growth, but there was almost zero impact on the perceptions of creditworthiness (and with the US as the controller of the global reserve currency nor should there be). US Treasuries rallied strongly as the flight to quality trade accelerated with fear gripping financial markets. We added interest rate risk aggressively over the month, increasing the underlying duration of the Fund by 3.5 years, to capture the capital upside.
Our bias was, and remains, to two of the highest quality AAA government markets, namely Canada and Australia, which represented 17% of the Fund’s assets at month-end. In early September we banked some of the profits in the core rates markets as valuations were becoming particularly stretched. Overall we believe there is little value in rates markets and one is far better trying to exploit curve and cross-market positions. However, signs of further crises could make valuations redundant so we are not willing to take duration down to zero.
Investment grade credit
August was one of the worst ever months for credit returns relative to government debt. Non-financial companies’ debt came under pressure with most issues struggling to keep pace with their respective underlying ‘risk free’ government bonds. Financial institutions’ debt sold-off significantly due to a stream of bad news. Not only did one have the dual macro impact of the sovereign crisis and weakening growth, there were also signs of increasing stress in the funding markets and ongoing US mortgage related litigation.
The impact of the financial institutions’ spread widening was mitigated somewhat by the 20% iTraxx Senior Financials CDS protection we had in the Fund. We chose to bank some of the profit on the hedge and rotate into a more macroeconomic related hedge. We retain 10% protection and would look to double this up again on any positive news that we regard as overly optimistic.
The weakening economic backdrop had a harsh effect on high yield bond prices. Default rates are always inversely correlated to GDP growth, but unless we see a large double-dip recession it is hard to imagine a large increase in the number of failing companies. As referred to above, corporate balance sheets are in pretty good health. High yield companies have termed out their debt maturities and there are relatively minimal refinancing needs required before 2014. Moody’s estimates the speculative grade default rate to be just under 2% for the next 12 months; our forecasts are conservatively in the 3-4% range, still below the 4.9% cycle average. With high yield bond spreads now at around 750 basis points higher, default rates are more than in the price.