| Bond prices and bond market comment |
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| Written by Gary Howes | |
| Monday, 28 September 2009 15:43 | |
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"it is mathematically likely that the year-on-year default rate will fall in the first quarter of 2010." Threadneedle comment on the outlook for the bond market: ________________________ The default rate on speculative grade bonds accelerated more quickly than we had anticipated and currently stands at a rate of 10.7% for the last 12 months. However, the peak in default rates is also occurring earlier than we had expected. The number of defaults per month has reached a plateau and, with the high numbers of monthly defaults witnessed in Q109 unlikely to be repeated next year, it is mathematically likely that the year-on-year default rate will fall in the first quarter of 2010. Bonds: peak lower than expected We had anticipated that the peak in default rates would be significantly higher in this cycle than in previous recessions. However, a number of distressed situations are ending in debt restructurings rather than defaults and this is resulting in a more normal peak level of around 12 to 13%. This is certainly much lower than had been priced into the market early in 2009 and this realisation has been a key driver of the dramatic rally of the past six months. The bond price rally was expected High yield bonds typically begin to rally ahead of the expected peak in default rates. Given that the market had been through its weakest-ever phase in 2008 and was pricing in extremely high levels of default, it is no surprise that the past six months have seen its strongest-ever recovery as default expectations have moderated. Scope for disappointment The market has moved a long way on improved sentiment and, if the rally continues, there will be scope for disappointment at the pace of default rate declines next year. For the time being, however, the market remains reasonably good value given the fundamentals, with spreads amply compensating investors for the risks involved. Economic recovery slow Recent economic data has been encouraging and we have been marginally upgrading some of our GDP growth forecasts for 2010. However, western government debt levels need to be addressed and consumer deleveraging is also likely to be a feature of economies in the coming months. Given these factors, we expect growth to be sluggish for some time to come. This has important implications for high yield bond issuers and is likely to lead to default rates declining more slowly after the peak than is normally the case coming out of a recession. What is the outlook for bond investors? We have been moving portfolios to a less defensive footing over 2009 to date, and we have now largely neutralised the previous underweights in cyclical areas. Among the bonds we have purchased are issues from Bombardier, Rhodia, Tui and ITV. However, funds are more conservatively positioned than might normally be the case at this stage in an economic cycle. This is because the strong outperformance of highly leveraged CCC-rated issues that might usually be expected at this stage of the cycle is likely to be muted by the anaemic nature of the recovery. Overall, we are maintaining a focus on companies with solid operations, strong cash flows and limited leverage – especially in cyclicals, where companies are likely to continue to find operating conditions difficult over the next few quarters. In terms of sectors, we are overweight in telecoms, energy and media and underweight in consumer areas. 
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| Last Updated ( Monday, 28 September 2009 15:51 ) |