Financial Journalist

FT Mandate 28 Feb 2001

Last year saw the Euro make a big impact on the bond markets, while emerging market debt grew in appeal, writes Gerry O’Kane

It has been a mixed twelve months for fixed income investment. Traditionally safe US Treasury bills (T-bills) and UK gilts have been through tough times, while high-yield corporate bonds have been the flavour of fund managers around the world, although they did not start last year that way.

The outlook for this year is also mixed. Goldman Sachs is estimating returns on global equities of 8.2%, commodities reaping a healthy 18% but bonds average out at 5.6%, while cash follows in at the bottom of the league with a 5.3% return.

While government bonds, especially those from the UK and Germany, are viewed as unattractive, January saw a record sum of new bond issuances. According to research company Capital Data, slightly less than $160bn of new issuances came to market, kicked off by mortgage-backed securities issued by the US-based Federal Home Loan Mortgage Corporation (FHLMC Freddie Macs) and the Federal National Mortgage Association (Fannie Maes).

Sovereign debt from emerging markets became attractive in some quarters, even though in September last year Ecuador failed to meet a US$44.5m coupon payment on one of its Brady bonds, becoming one of the first failures in sovereign debt since before second world war.

Even so, J.P. Morgan’s Emerging Market Bond Index (EMBI) returned 18% to investors in 1999 and this year is likely to see a record amount of emerging market debt come to the dealing place.

The advent of the euro opened other bond markets and saw fixed income activity in markets such as Italy hit record levels.

Paul Read, head of fixed income markets with Perpetual admits that 1999 was something of a bear market in bonds and some careful management became a necessity. “Generally speaking government bonds were losing money,” he says.

Falling returns on government bonds in G7 countries saw institutional investors such as pension funds and insurance companies, look for higher yields in some emerging markets, while other fund managers looked to high yield European corporate bonds.

Although emerging market bonds, low grade corporate bonds, preference shares and convertibles offer very different risk and return profiles to those of gilts or T-bills, they were seen as offering better opportunities.

The UK long-term gilt markets had the worst performance. A benchmark index of 15-year gilt issues fell by 0.4% over 1999, even after taking income into account. Institutional investors were the main reason for their poor performance.

After having fled to bonds following the collapse of emerging markets and the Russian hiccup of 1998, the equity markets began recovering and institutions began offloading some of their holdings. Ironically according to a Barclays Capital gilt/equity study, returns on gilts between 1990 and 1998 were higher than for UK equities.

According to Theodora Zemek, head of fixed income funds with M&S Asset Management, there were other reasons that had made gilts attractive. “Pension fund managers were persuaded by actuaries to hold gilts,” she explains. But in recent years other influences played a role in their falling returns.

“In 1994 the Conservative government announced that corporate bonds issued by UK companies would be eligible for personal equity plan investment - gilts were never included,” she points out.

The collapse of Russia made government paper attractive until the expected global economic meltdown never happened. “There are other factors in the long term decline in gilt yields such as low inflation both in the UK and globally and prudent policy by the current government means that they do not need to raise as much money through borrowing,” says Ms Zemek.

The yields of long term gilts and treasury bonds have been driven ever-further downwards as pensions and insurance firms hang on to them because of increasing demographic factors.

What is going to happen in the coming year is open to question. In the UK minimum funding requirements, which regulates pensions, not allowing them to take excessive risks with investment, are under review. Some fund managers believe changes could allow more investment in corporate debt.

In the US, 30-year T-bill yields have fallen below 10-year and five-year notes but there are indications that government could reduce outstanding debt and begin buying back long-term treasury issues.

Possibly the most surprising aspect of the debt market in 1999 was the attraction of emerging market debt. Despite of Ecuador’s failure on the Brady bond, investor reaction was not only muted but the second half of the year saw sovereign Latin American debt dominate the market place, with Mexico releasing an especially successful bond.

With the poor return on G7 sovereign debt, emerging markets offered something a little more exciting. According to fixed income emerging market managers, since the default of Russia and the gradual recovery of markets, especially in Asia, not all emerging debt are tarred with same brush.

Managers have become more discriminating and this has been reflected in the gradual narrowing of interest rate spreads and their economies improve.

“The main focus, as always is Latin America,” says Julian Adams, head of emerging market debt at Aberdeen Asset Management. “This region still represents the bulk of any emerging market bond index, and, in today’s environment, this is where you will get some of the best performance. As Latin American markets recover this year, sovereigns will improve markedly as credits.”

Mr Adams also points out that retuns on emerging market debt have a low, sometimes negative correlation on other fixed income asset classes such as government debt or high-yield bonds.

He says: “Emerging market debt is a natural hedge against growth and inflation, the ghouls of G7 bond markets.”

Euro, bond markets, emerging markets