31 October 2013

Macro Strategy Update

Market Update

In the recent October US Federal Reserve meeting, the Fed has decided to hold off tapering for a while, which is bullish for risk taking. However the market action from fixed income markets continues to worry us. Although high yield bonds (a.k.a. junk bonds) have recovered from the summer selloff and are positive on a year-to-date basis (see Figure 1), the riskiest portion of the junk bond universe continues to languish. CCC-rated yields remain elevated and the spread between BB- and CCC-rated bonds continues to widen (see Figure 2). What this means is that investors are demanding higher yields from the riskiest companies, a sign that all is not well in the high-yield universe.

In a recent survey by the International Association of Credit Portfolio Managers (IACPM), credit spreads are poised to widen over the next three months, causing corporate defaults to rise. The outlook for both investment-grade debt and junk-rated borrowings in North America are in negative territory indicating deteriorating conditions.

Neither interest rates nor credit defaults can go any lower, so the next move would have to be higher rates and, in turn, a larger number of defaults. Many companies have avoided defaults with very low interest rates but they will no longer be able to do that when rates start to go up.

Investors need to taper bullish expectations even as we head into the seasonally positive period for equities.

Image courtesy of Stockcharts.com

Figure 1: High yield bonds have recovered from the summer sell off.

Figure 2: Spreads between CCC and BB bonds continue to widen.

Portfolio Positions

We have avoided exposure to high yield bonds for some time due to concerns that the party was ending and recent indicators are now showing that our fears are coming true. Whilst we remain mildly bullish on the global economy, recent indicators are showing cracks appearing in the US market bull run. Apart from concerns on the riskiest companies as explained above, we are also seeing divergences in equities which suggest some caution. We are monitoring these indicators closely and are considering paring down our risk assets if these indicators persists. Watch this space!

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