Emerging market bonds and corporate bonds are still attractive, particularly compared with government debt, where negative real yields are resulting from central banks' low interest-rate policies. Limited pressure for a significant increase in interest rates
Global interest rates came under pressure in the first quarter of 2013, with 10-year government bonds from the US and Germany reaching yields of 2 and 1.7 per cent, respectively, for the first time in a year.
Increasing speculation that the major central banks would scale back their expansionary, unconventional monetary policies sooner rather than later also surrounded the market.
The counter-argument is that global growth remains moderate, with no inflationary pressure.
A reduction in monetary stimulus is not expected any time soon and in their recent meetings many central banks have even resumed a more cautious stance.
Moreover, a new major player – the Bank of Japan – recently announced a new phase of monetary easing in an attempt to eliminate the deflation that has troubled the country for almost two decades.
The rise in interest rates should remain limited therefore, but government bonds remain unattractive in the context of asset allocation.
Emerging market bond segments offer attractive real yields
Local emerging market government bonds, especially inflation-linked ones, were top performers in the first quarter of 2013, followed by hard-currency emerging market corporate bonds.
Hard-currency government bonds, in contrast, suffered losses of around 2 per cent, and credit premiums subsequently experienced a correction.
At close to 3 per cent, the current level of credit premiums corresponds to the historical average, while fundamentals continue to improve.
Continued growth in emerging markets and positive US economic data will continue to drive performance.
Investors should consider emerging market inflation-linked bonds and corporate bonds as part of their asset allocation as a result.
Corporate bonds are still flying high, but the air is getting thinner
Although corporate bonds delivered positive excess returns relative to government bonds in the last quarter, there are developments that warrant caution.
New issues, not only from the high-quality issuers, are finding a ready market.
A number of perpetual corporate bonds have been placed easily in large volumes, issuers with no or bad credit ratings are appearing, new issue premiums disappearing and absolute risk premiums are steadily shrinking.
However, the fundamental condition of companies is still excellent, growth prospects are likely to have a favourable impact on profitability, merger projects are still sound and default rates remain modest.
The continued demand for corporate bonds – not least as an attractive alternative to cash investments or government bonds – is likely to shore up the market for the time being.
However, picking the right companies will become increasingly important.
In addition, concessions on quality coupled with inadequate risk premiums could take their toll in the future. In this environment, a strong diversification strategy, across instruments and countries, is crucial.
Expensive short-term bonds in all sectors and rating categories should generally be reduced. High-yield bonds, with issuers of BB rated bonds of particular interest, look attractive based on risk and valuation considerations.
Bernhard Urech is head of fixed income and interest rates at Swiss & Global. The views expressed here are his own.