''All is not lost - yet''
2 June 2006
C21
Credit Strategy
Exit High Yield over the coming months. Own defensive Investment Grade bonds. Avoid EM markets for time being but look for selective entry points
The weakness in the equity markets has spilled over into credit. European high yield bonds have widened out by 38bp since their trough at the end of April. Emerging Market bond spreads have also widened out by 52bp since the beginning of the month. The 'risk aversion'trade could be over done in the short term, but the outlook for credit markets is turning.
We had highlighted a risk to these markets in the second half of the year as economies cool, defaults start to rise and higher borrowing costs affect the more leveraged in these credits. Investors should use any equity market induced bounce to reduce positions and get defensive. The following table summarises the influences on the credit markets. Some of the factors can change dramatically if equity market sentiment improves but the longer term influences (global growth and borrowing costs) will be increasingly less favourable in the second half of the year.
Emerging markets were just as vulnerable to the reversal of liquidity story as high yield but there is an added concern. One of the central themes driving emerging sovereign bonds ahead of their corporate counterparts had been the improvement in their current account balances. In many cases, these improvements are due to the benefits of higher commodity prices on trade. With commodities reaching extreme pricing levels the risk of overplaying this benefit was immense. We sold out of our South African rand and Brazilian real positions once commodity charts started to point straight up.
Portfolio Response :
- The game in emerging markets debt has changed. Careful focus on countries with long-term improvements in their balance of payments (not just commodity froth) will prove beneficial. (See previous article "Carry on up the glacier"). We will be looking for opportunities to add emerging debt positions from here.
- High yield corporate bonds will remain a hostage to the equity markets in the short term. Given the expected deterioration in the outlook, investors should use rallies as an opportunity to lighten up.
Important Information
The views and opinions contained in this document are those of Newton Capital Management Limited at the time of going to print and should not be construed as investment advice. Newton Capital Management LLC provides marketing services in the U.S. for Newton Capital Management Ltd. Newton Capital Management Limited is an investment management firm authorized and regulated in the United Kingdom by the Financial Services Authority in the conduct of investment business and is a wholly owned subsidiary of Mellon Financial Corporation Inc. Registered in England no: 2675952. 'Newton' refers to the Newton group of companies that include Newton Investment Management Limited and Newton Capital Management Limited. Assets under management include assets managed by Newton Investment Management Limited, Newton Capital Management Limited, Newton International Investment Management Limited and Newton Fund Managers (CI) Limited. Newton Capital Management LLC, Newton Capital Management Limited, Newton Investment Management Limited, Newton International Investment Management Limited and Newton Fund Managers (CI) Limited are affiliated entities.
Please remember that the value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.Past performance is not a guide to the future. The value of overseas securities will be influenced by fluctuations in exchange rates.
The information contained in this document should not be construed as a recommendation to buy or sell a security. It should not be assumed that a security hasbeen - or will be - profitable. There is no assurance that any security will remain in a portfolio.
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