CIO Viewpoint - ’009 Bonds: Shaken but not stirred...yet

Julian Chillingworth, chief investment officer at Rathbone Unit Trust Management, on a new era for bonds...

It is a cliched denouement. A struggle ensues; the hero gets shot, the hero appears to be dead. But lo and behold, he is saved by an intervening force that takes the blow instead. He lives, he stands, and this to rapturous applause and relief. In 2009, investors felt similar exuberance when they were woken from their anxieties by extraordinary fiscal stimuli, having survived the blows of the credit crisis. Investors were stunned, but were still breathing. The real hit, of course, was taken by the biggest ‘hero’ of them all, the bond market.

A year of gains

The rally of 2009, one of the sharpest on record and, indeed, one of the most potent in terms of the assumptions it has challenged, appears to be stuttering. Any expectations of a Santa Claus rally are wearing thin as investors look back on a year of huge gains, and decide to profit-take. However, where the risk lay firmly to the upside in 2009 – in other words, worry about missing out on potential returns – downside risk is now (rightly) back on the agenda.

Indeed, 2010 is likely to be a year where gains are accompanied by volatility, and the pricing of risk is reviewed.

The implications of massive fiscal deficits will imbue a sense of trepidation into markets in 2010. Nervousness in government bond markets is already starting to illustrate this point. Downgrades by rating agencies, threats of downgrades, governments bailing out other governments (and the danger of unfulfilled promises), have all pushed the issue of sovereign debt risk to the fore. Spain, Greece, the UK and Dubai (in that order), are all cases in point.

Market collapse

A worst case scenario would see a country’s bond market collapse under the weight of its own debt, pushing up yields to unfavourable levels and the debt closer to default status. Sovereign integrity is vital at this juncture because much of the stimuli, and therefore hopes for a sustained recovery, remain predicated on government bond issuance. Let’s break this down.

The future of the G7 has been mortgaged to the tune of $11.89 trillion – it’s a staggering amount. A recent poor take-up of auctions – à la the US – suggests bond investors are increasingly sceptical about the ability of governments to finance their debt. In theory, any claw-backs should result in higher taxes, cuts in public spending, and higher bond yields as the quantitative easing programme is abandoned and interest rates start to rise. The implications for once-heady growth rates are obvious.

Specifically in the UK, interesting points are being made about the fudging of fiscal policy in the pre-Budget report. Whereas Ireland has been unequivocal about its painful spending cuts (and its bonds were subsequently rewarded by the market), the UK’s one-off bonus tax effort has pulled UK Gilt yields upwards. It suggests investors are being selective and looking at fundamentals – a key trend for 2010.

The bottom line is the bond markets are only patient to a point. Bank lending into the economy can only start in earnest once economies start to stabilise (essentially meaning once fiscal positions look sustainable), and crucially, borrowers will only take up the baton once they are convinced their jobs are secure. The ‘tectonic’ adjustments we have all faced since the 2007 will continue over the next 12 months. It is likely to be a more volatile ride than 2009, although not without gain. The illusion of a risk-free asset has been torn away like a comfort blanket. A colder march towards that brave new world continues.