US Debt Markets
The world's most visible bond fund manager, Bill Gross, has made a sizable bet that interest rates are going higher, as he reduced his funds' holdings in US Treasury bonds to zero and shortened the funds' duration.
While we understand his reasoning, the timing of his move so many months before the Federal Reserve is scheduled to end its bond purchase programme (at the end of June) strikes us as odd. Given that the Fed will be buying bonds for four more months, it seems too early to shorten duration as there is a significant risk that he will face several months of underperformance. For example, if spreads tighten, or if they even stay flat, he will lag the index. In addition to making the bet that interest rates will rise after the Fed stops buying bonds, he also appears to be making a secondary (and maybe unintended) bet to us. That second bet is that the market won't flock to Treasury bonds, sending their prices up, as a safe-haven investment if either the Middle East situation or sovereign credit issues in Europe worsen in the near term.
Of course, this is Gross that we are talking about, and whatever his strategy is, it is never the obvious. While the clear takeaway from the headlines is that he expects a sharp increase in interest rates within the next few months, we don't know what other manoeuvres he may have made in the futures and options markets before the funds' February holdings statement was made public. So while it appears that he has made a huge bet by underweighting Treasury bonds, we suspect there is another angle that we are not seeing.
The Morningstar Corporate Bond Index widened slightly last week, ending at +139, 2 basis points wider. Increased fighting in Libya amplified Middle Eastern tensions, and fears of a global economic slowdown--as China's trade deficit was less than expected--overshadowed positive economic news in the United States. The finance sector took the brunt of the widening as investors watched sovereign credit spreads widen for the European periphery nations. US Treasury bonds rallied as the 10-year bond tightened 14 basis points to 3.40%.
Trading activity was relatively subdued last week and extremely quiet Friday. After the Japanese earthquake, investment managers combed through their portfolios to determine which banks and insurance companies may be most affected. In addition to identifying those issuers directly affected, they also were picking out which bonds they thought insurance companies may have to sell to raise funds to pay claims. As we have seen in the past, many market participants will try to front-run the insurance companies by selling these bonds ahead of them with the intention of being able to buy them back cheaper.
Europe
Corporate credit spreads in Europe widened about 4 basis points over the course of last week, with the financial sector significantly underperforming the index. In addition to the concerns that the global economy is slowing, European investors also have to contend with the continued sovereign debt overhang.
European Union bankers and politicians met Friday in Brussels to try to negotiate terms for a long-term, comprehensive plan to tackle the banking issue. Headlines throughout the week highlighted the political posturing going into the meetings, as each side argued its case in the media. For example, Ireland and Greece asked for lower interest rates on the bailout funding they've already received, while the bankers are asked for the size of the European Financial Stability Facility (EFSF) to be increased to cover the potential requirements to bail out Portugal. Germany was requiring that Greece sell state assets and that Ireland increase corporate tax rates.
On Saturday, eurozone policymakers agreed on lowering the interest rates on Greece’s bailout package and empowering the EFSF to use its full lending capacity of EUR 440 billion, up from the current limit of EUR 250 billion, and invest in government bonds. Details of this agreement and how the financial burden will be shared between the eurozone’s member states are yet to be clarified.
The downgrade by Moody's of Spain's rating was not in and of itself newsworthy, as the markets already trade the country's debt at levels well wide of AA rated-type credits. What was significant was that Moody's released its estimate for the amount of capital the Spanish banks need. Moody's pegs this figure between EUR 40 and EUR 50 billion, which is almost double the amount that Spain itself is requiring the banks to raise. This calls Spain's estimates into doubt.
On the bright side, Portugal was able to issue EUR 1 billion of two-year notes at about 6.00%, which is about a 400-basis-point spread over Bunds. This issuance provides some additional breathing room; as we mentioned last week, the country reportedly only has EUR 4 billion of cash and will require EUR 20 billion in financing this year.
As we've opined on many occasions, we expect the sovereign credit overhang will continue to limit the amount that European corporate bonds will tighten until a long-term, sustainable financing plan for the peripheral sovereign issuers is implemented.
This article has been additionally edited by Dea Markova, Assistant Online Editor for Morningstar.co.uk
