of fixed income with very, very poor liquidity.”
Liquidating positions will be more difficult as banks have shrunk trading books to comply with new regulations forcing them to hold more capital, such as Basel III. Primary dealers at US investment banks have reduced their corporate bond inventory by 77% since late 2007, according to FitchRatings. In November, UBS shut its high yield bond trading desk in London as part of a plan to cut 10,000 jobs and curtail its investment bank.
Wary of liquidity risk, M&G Investments has cut risk by selling commercial and residential mortgage-backed securities and other forms of structured credit. “We’ve taken all of our chips off the table,” Lloyd says. “We’re sitting on the fence so much that it’s beginning to hurt.”
2013 outlook
Corporate debt should stay in investors’ asset allocations as a widespread shift from government bonds to equities, dubbed the “great rotation”, begins in the second half of 2013, says Bank of America Merrill Lynch.
Low interest rates and high liquidity will continue to underpin the US and European corporate bond markets and drive gains of up to 7%, the bank forecasts. The senior debt of European financial companies and bonds issued by US banks and insurers should benefit alongside out-of-favour equities and other risk assets if Europe stabilises further and Chinese economic growth re-accelerates.
Within the US and European economies, corporate balance sheets have reached their “peak strength” and may soon show modest increases in leverage as executives seek to expand business operations, says Mitch Reznick, co-head and lead researcher at Hermes Credit.
Improving business sentiment may spur merger and acquisition activity, capital expansion projects and new hiring. Large companies, such as telecommunications provider AT&T, have invested in new operations while maintaining their credit quality, says Murfin at Blackrock. Smaller, cyclical businesses are generally less capable of this, and the growth ambitions of financial companies may be stunted by capital-adequacy laws. “2013 could be the year in which chief executives start to use huge cash piles to appease equity holders,” Murfin says.
Pension fund clients of Mercer Investment Consulting are being advised to seek attractive yields in unlisted real estate and infrastructure assets instead of bond markets, says Paul Cavalier, the company’s global head of fixed income research. “We’re seeing demand, but not as strong as it should be” as investors are cautious of long-term illiquidity, he says.
Investors who sell corporate bonds could miss late, momentum-driven gains, says Wauton at Aviva Investors. He is focusing on relative-value trades, such as choosing between the senior and subordinated debt of financial issuers, rather than making “big bets” on when interest rates may rise.
“The art of fund management is timing. It’s about knowing when it’s appropriate to derisk because it is a new regime,” Wauton says. “If we take our profit now, where are we going to put it?”
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