Marc Seidner is Director of Domestic Taxable Fixed Income at Standish Mellon. In this capacity he oversee the management of about $24 billion of Core High-Grade and Core Plus portfolios.
Bonds Should Be Back
The consensus forecast for 2002 anticipates that GDP growth will resume over the course of this year and achieve a year-over-year rate in excess of 3% by the fourth quarter. This forecast implies a V-shaped recovery propelled by low interest rates, fiscal stimulus, lower energy prices and liquidity from the refinancing wave of late last year. It assumes that the positive forces will more than offset economic headwinds, including job losses, weak corporate profitability and stretched consumer and business balance sheets.
A resumption of GDP growth should be anticipated in 2002. But, the most likely scenario is a fragile, uneven recovery--closer to a W than a V. The good news is that this is likely to lead to a benign environment for the bond market.
There are several investment themes for 2002. The consensus view expects a near-term inflation risk from the massive liquidity that has been injected into the economy. This sentiment was behind the rise in long-term interest rates last November and December, which steepened the yield curve. The forward market is also anticipating significant tightening by the Federal Reserve, implying a fairly sharp recovery and a sharp 177 basis points increase in short-term rates in 2002.
The consensus argument overlooks the weakness of aggregate demand and the amount of global excess capacity. Thus, our first theme is that the disinflation we have experienced in recent years is likely to continue in 2002, despite the low level of short-term interest rates. The implication for portfolios should be to maintain a duration position longer than the benchmark and a bias toward a flatter yield curve. We suggest overweighting positions in the three- to five-year area of the yield curve. That area should benefit from capital appreciation, assuming the yield curve remains steep, as their maturities shorten (a strategy known as "rolling down the curve").
At the long end of the curve, with no further issuances of 30-year Treasury bonds planned, this maturity is likely to benefit from lack of supply. Both government and corporate issues at the long end would gain from continuing disinflation.
Another important general theme is the improving trend in corporate credit quality. This may sound contradictory to our first theme, which suggests that the recovery may not be as robust as expected. It really is not, however, when you consider how the downturn has forced corporations to rationalize their balance sheets through deleveraging, cost-cutting and asset sales.
Statistical verification of this trend should become more definitive this year, as Moody's Investors Service has predicted that the default rate should peak in the first half. Similarly, we expect Moody's upgrade/downgrade ratio to bottom out this year for investment-grade issuers. Thus, an overweight in corporate credit, particularly investment-grade bonds, should positively impact portfolio performance. Event risks such as Sept. 11 or Enron, however, show that careful selection and vigilance among corporate credit is a key factor for success.
Our final theme involves continued elevated levels of bond market volatility. The growth in volatility over recent years has several causes, but a major factor has been the tremendous growth of the mortgage-backed securities (MBS) market. Many institutional investors have overweight allocations of MBS relative to their benchmarks. However, these securities tend to underperform in volatile markets. Thus, we think an underweight allocation of MBS, at least for the first half, will enhance returns in 2002.
In sum, we think that modest growth and a low inflationary environment this year will be favorable for fixed income. However, careful issue selection and the patience to ride out bouts of volatility should be prerequisites for prudent investors.