Fixed Income. 2013 Preview: Nothing Is (Im)possible

December 25, 2012

 

The performance of most bonds at end 2012 promises to be impressive. Liquidity injections by leading central banks, the main tool against the financial crisis, have sent interest rates in developed markets down to almost zero. Moreover, the key guide for such rates, the US Federal Reserve, has indicated a commitment to keeping regulatory rates low until 2014. This scenario has thus created space for higher investment activity in emerging markets. However, US and European economic problems and the EU debt crisis have dramatically increased volatility, which in turn has significantly limited investors’ risk appetite. Thus, risky assets like equities have not really been considered appropriate destinations for fund allocations. Of course, it is no surprise that the Russian bond market’s performance has been much stronger than that of the equity market. Current demand also stimulated issue activity on the primary market, already setting a new annual record for the CIS. Furthermore, high_grade issuers have dominated the reinvigorated placement activity.

Unfortunately, bondholders can hardly expect 2012’s heights to continue in 2013. Of course, opportunities exist, but we doubt that high results can be achieved using a buy-and–hold strategy for benchmark instruments. Spreads and nominal yields are very low, so further significant compression seems unlikely. For example, the yield on the Russia 30 would need to decline 150 bps in 2013 to offer double-digit returns to holders. Given the existing spread over the UST curve (some 170 bps), this scenario would assume compression to 20 bps, well below the historical lows observed in 2007 (about 90 bps). Of course, the nominal yield on corresponding US Treasuries (1.0% per year) may decline significantly, which would then require less extreme spread compression. However, we do not think that even the unlikely combination of these events will emerge to allow the Russia 30 to offer a double-digit return next year.

However, based on the impressive results for 2012, we do expect new inflows to fixed income funds at least in 1Q13, as inertia in investors’ thinking is high and there is no obvious growth story to drive a rapid reallocation into a different asset class. The latter fact means that these investors will allocate enough money to support a high level of purchasing capacity. We believe that the market will at least make an attempt to leap above 2012’s high bar in terms of performance. Nothing is impossible, but investors would need to use new approaches and/or instruments to replicate 2012’s success.

Furthermore, we expect investors to become more aggressive in 1Q13. There will be no need to protect existing profits as in 4Q12, and the priority will likely shift to searching for relatively cheap assets. We expect this trend to fuel supply on the primary market. Given narrow spreads and low nominal yields on benchmark Eurobonds, we see many opportunities for low-rated or second-tier borrowers to tap the market with new issues, as well as room for further spread tightening for these issuers on the secondary market. Overall, we see a high chance of a “hunt for yields” opening on the market in the beginning of 2013.

Another more or less obvious way of adding risk to positions is to increase local currency assets. In the CIS space, the most interesting opportunity is the Russian ruble bond market. From a fundamental point of view, there is reason to expect interest rates will decline as inflation is likely to decelerate. Furthermore, with strong oil prices, most investors are not afraid of ruble devaluation, and nominal interest rates are relatively high (about 7% for long-term bonds), which has pushed these bonds onto investors’ radar. In terms of technicals, we expect this market to attract greater attention from international investors as Euroclear/Clearstream receive full access to settlement at the very end of 2012. Last but not least, the market’s size ($98 bln in OFZ, $132 bln in local corporate ruble bonds) is large enough to fit the liquidity requirements of even jumbo international investors. All these factors make ruble bonds likely one of the most interesting assets in the CIS space.

Prepared on the basis of the report “Fixed Income. 2013 Preview: Nothing Is (Im)possible” by Sberbank Investment Research.