Opportunities in the fixed income markets
February 1, 2013
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Joseph R. Baxter
Senior Vice President, Head of Municipal Bond Department, Senior Portfolio Manager
For us, the most attractive sector of the municipal market at present resides
in the lower-rated, higher yielding categories. If macroeconomic conditions
remain similar to those of 2012 in which the stock market would rise amid
modest economic growth, forcing investors to continue their search for yield,
we can potentially envision a scenario in which BBB-rated and high yield bonds
continue to generate strong performance. These securities have historically
outperformed in a rising rate environment in which rates tend to rise in a slow,
controlled manner. If the economy grows much faster than the roughly
2% growth seen in recent quarters, however, and if rates move significantly
above current levels, all rating tiers could face significant headwinds.
In addition, ongoing fiscal negotiations on the debt ceiling, sequestration,
and the annual budget process could cause volatility in the financial markets.
More specific to municipal bonds, the tax-exempt market may experience
some volatility, as it did in December 2012, due to the ongoing possibility of
proposals that call into question the sector’s tax-exempt status.
All of these things — the threat of higher interest rates, the uncertainty of fiscal
policy negotiations, the specter of tax policy changes — may cause ebbs and flows
during 2013 in the municipal bond market. However, markets tend to overreact to
short-term headlines, which may provide opportunity for patient investors.
Roger A. Early, CPA, CFA, CFP
Senior Vice President, Co-Chief Investment Officer —
Total Return Fixed Income Strategy
Overall, yields in the domestic bond market are very low on a nominal and real
basis, but we believe there are pockets of opportunity. We especially like investment
grade corporate bonds and mortgage-backed securities, the latter of which is
currently yielding about 2.25% (source: Bloomberg). On the Delaware Investments
Fixed Income team, we often buy mortgage debt through a delayed settlement
procedure, looking to take advantage of various anomalies in the market. In many
cases, we’ve been able to end up with a mortgage bond that’s rated the same as a
Treasury but with a 100 – 150 basis point spread in the 5 – 7 year area of the curve
(note that 100 basis points equal one percentage point).
That yield pickup speaks to the benefits of active management. The low rate
environment that we have endured for several years now provides very little
cushion for price volatility. Over time, though, our credit research capability has
added measurably to total return. It’s a matter of blending all the pieces of a
multisector asset class together in a way that attempts to maximize yield while
dampening volatility, such as by including some short-duration plays to build a
defensive component to a portfolio. Looking at interest rates generally, we think
yields are expected to end 2013 a little higher than they are today. But rates
won’t head up in a straight direction, in our opinion. There are too many difficult
economic and political issues left to be settled in the United States, China,
and Europe to expect an abrupt spike in yields.
Paul Grillo, CFA
Senior Vice President, Co-Chief Investment Officer —
Total Return Fixed Income Strategy
Given the massive amounts of liquidity central banks continue to inject into
the global financial system, we believe higher-beta areas of the market currently
provide the more favorable opportunities. This assumes, of course, that the
Federal Reserve and other major central banks continue to keep the liquidity
“spigot” open. We specifically look to emerging market corporate debt as an
area of opportunity. It’s important to note, though, that this is not simply a
top-down (macroeconomic) sector call. For the last year-and-a-half to two
years, the more attractive opportunities have been generated by individual
security selection. Company- and issue-specific research has made the
difference in relative performance during this time frame.
We continue to believe that developed market sovereign bonds will face
challenges in 2013. We expect yields to rise at least slightly in some nations,
a process that already is under way. Currencies also could come under
pressure. Shinzo¯ Abe, the new Japanese prime minister, has been outspoken
about wanting the Bank of Japan to crank up the printing presses — and not
in a half-hearted way this time. We also expect the British pound to move
lower after Mark Carney takes over at the Bank of England and further eases
monetary policy as we expect him to do. The recent rally in the euro has some
characteristics of a temporary move, but at least the peripheral nations like
Greece, Spain, and Portugal do become more competitive at that level. When
you add up all these factors, we think there is a strong case to be made for
taking some money off the table in developed countries.
We also are not finding much value at present in the U.S.-dollar sovereign
emerging market space. This government sector had an exceptionally strong 2012, posting gains of about 15%. The rally compressed spreads to levels that no longer
represent good value, in our opinion. Notably, however, the corporate emerging
market sector remains attractive to us. We believe it still offers a reasonable yield
of about 4.5% and perhaps up to 50 basis points of spread compression left to go
this year, thanks to the massive amount of liquidity created by world central banks.
There should also be less pressure on currencies in the emerging world because
of their higher interest rates. Those yield levels make local-currency emerging
market government bonds attractive to us. Currency plays among the high yielders
can be attractive in the forward market as well. The currency forward instruments
can give an investor a more liquid entrée into these markets. Relying on currency
levels can be a tricky game to play, however, since some countries — most notably
Brazil in late 2012 — have tried to talk down their currencies to remain competitive.
On balance, though, we think the combination of yield and currency could make
emerging market debt one opportunity to consider in the global fixed income
markets this year. (Source: Bloomberg.)
Thomas H. Chow, CFA
Senior Vice President, Senior Portfolio Manager
A little perspective is in order, in my opinion, when looking at investment grade
corporate bonds. We’ve just experienced several very good years and at least
one great year, and the sharp downward move in yields over that period has
removed what once was, in my opinion, a terrific opportunity in the corporate
bond space, at least from a tactical standpoint. In the current environment, we
believe investment grade corporate bonds may be viewed by some investors
as a nice complement to a diversified fixed income portfolio.*
Even with yields near all-time lows, however, we believe there is room for some
additional compression, especially in the high yield space, where the outlook
for defaults remains very positive. At the height of the financial crisis, credit
spreads on high yield bonds (or, their yield above a risk-free Treasurys) peaked
at around 2,000 basis points. Currently, they are around 500 basis points,
which is still slightly above the long-term average. (Source: Bloomberg.)
Those figures mask a broad range of spreads, however, and the purpose of
our research is to identify value. For 2013, we believe total returns within the
high yield and investment grade markets should largely depend upon whether
the Fed stays the easy-money course as indicated, and whether investors’ risk
appetite remains healthy. As has been the case for quite some time, however,
we continue to believe that the potential for significant volatility in both yields
and spreads remains across the entire corporate fixed income sector.
The views expressed in each outlook represent the Manager’s assessment of the market environment as of January 2013, and should not be
considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to
change without notice and may not reflect the Manager’s current views. The views expressed in each outlook are general in nature and do not relate
to a particular mutual fund.
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