Bearish caution sets in as the exuberance of 2003 dissipates

2003 saw strong performances from fixed income strategies but spreads are now starting to offer less value

Fixed income managers became cautious in the last month as many saw opportunities become more security-specific.

Distressed, high-yield emerging and developed markets, and relative value/arbitrage funds performed well in 2003. Distressed and high-yield fixed income have, in fact, been good investments for the last two years due to a consistent tightening of spreads which managers have been able to play.

However, that situation has worsened and now the question is whether there are still reasonable values in these areas with spreads where they are, according to Omar Kodmani, senior investment officer at Permal.

"Fundamentals are still good, but valuations are quite stretched," he says. "I draw a parallel to the stock market. The last nine months have been very good for stock market indices in Europe and the US. The general fixed income market is going forward more credit by credit."

High-yield managers have performed well, essentially for the same reasons as distressed, because the lowest-quality credits have performed well and there has been a lot of spread tightening, says Kodmani.

Managers now have to be more cautious, he says, because "the big move has taken place" and opportunities have become more security-specific.

In emerging markets, Brazil and Russia are the big drivers, and although they have very different fundamentals, both show upward trends.

Relative value/arbitrage is a much less market-dependent strategy than others, according to Kodmani. Going long/short similar securities and trying to extract a return from the pricing anomaly between the two is less volatile, but also has less upside than other fixed income strategies. It is more about security selection and does better in a stable market environment than during periods of volatility.

David Palmans, senior analyst at Altin, believes opportunities are likely to increase for distressed funds.

Factoring in strong US economic growth in 2004, credit spreads in high-yield are tight, he says, and it is unlikely spreads will compress further. Strong returns are not expected.

Managers should initiate short positions in bonds issued by good companies and buy more distressed paper on the long side to reduce overall debt exposure to the credit market, he adds, betting on the fact that if the US economy improves distressed debt will perform better than in the high-yield market.

Emerging markets had a strong run last year and many investors have now switched from long emerging market debt to equities, especially in Asia, he adds. Altin has reduced debt positions in Latin America to put into Asian equities. Core exposure via distressed and high-yield markets has been reduced by switching to bank debt.

The company has a 12% allocation to distressed debt, half of which has been switched from public distributed debt to floating rate notes. It still has 7% exposure to high-yield bonds, but plans to cut this to around 5%.

Investment grade bonds have underperformed the gilt and high-yield market this year. Gilts have also been volatile and are expected to continue to be so, leading to ongoing volatility in the investment grade market, says James Foster, director, head of credit at ISIS Asset Management. The bond market is expecting interest rates to rise in the US and in the UK, he adds.

In the investment grade market, yield spreads widened sharply back to their September 2003 levels. Market mood has changed with the over-exuberance of 2003 starting to dissipate.

Figures from Moody's have shown speculative grade defaults for 2003 at 5.2%, above the 4.9% long-term average, but with estimated figures for 2004 at 3.4%, "this should provide support for the high-yield market," he says.

A growing desire for income from equity shareholders is one area of concern for bond investors, says Foster. "So far during the recovery, the focus of companies has been repairing balance sheets and paying down debt. However, equity investors want to reap their share of the rewards from successful companies. As such, the concern is that this could lead to higher corporate borrowing," he says.

Key Points

Tightening spreads have made many markets profitable but there may not be any value left at such levels

Emerging markets, led by Brazil and Russia, have performed well but investors are moving into equities

Strong US growth in 2004 should enable distressed debt to do well