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Watching the Central Banks: Bonds in the Second Half of 2015

Divergence between the Fed and the ECB and Bank of Japan set up opportunities in deviating rates and forex.

The story of the global bond market today could be a tale of the central banks. Essentially, it is the Fed versus the rest of the world — although the Greek debt crisis might play a hand. Strong U.S. data this month, especially in retail sales, has led us at J.P. Morgan Asset Management to reiterate our opinion that the Federal Reserve will move rates higher in September. Meanwhile, other central banks in the developed world, such as the European Central Bank and the Bank of Japan, remain focused on expanding their balance sheets. That divergence should continue to throw out some interesting relative-value opportunities in deviating rates and foreign exchange markets, which we can trade in portfolios.

Recently, the broader movement in government yields has also shaken up some corporate bonds. We have sharpened our pencils accordingly to add some attractively valued corporate paper in investment-grade and high-yield debt.

On the credit side, a number of factors are affecting the investment-grade market, pushing spreads wider. The U.S. dollar market is experiencing high levels of new issuance, which has put pressure on spread levels. Supply is up 19 percent year-to-date versus 2014 as companies rush to issue before any rate normalization takes off. Another theme that has emerged in the U.S. is the increase in mergers and acquisitions and share buybacks. These trends also explain the high supply levels. Companies are using their cash to acquire others with established product development pipelines. Share buybacks have been especially popular in technology and telecommunications. With underlying yield curves steepening, we think credit curves will flatten.

For a long time the euro market experienced negative supply dynamics. Yet with investors having to digest €37 billion ($41.3 billion) of net positive supply over the past two months, this has changed. Year-to-date, U.S. issuance of euro-denominated bonds constitutes 25 percent of all euro bond issuance. Certain sectors have particularly suffered from the supply. Subinsurance spreads have widened, with companies bringing new bonds to an already saturated market.

According to recent surveys, investors are heavily overweight in corporate bonds relative to their benchmarks. A number of implied volatility indicators have ticked up over the past month as a result of the move in underlying government bond yields. Although there is no panic among investors, we will remain wary of factors that indicate deterioration in sentiment, specifically fund flows turning negative. We have an overall Underweight on investment-grade bonds, driven mainly by our Underweight to the U.S. dollar market.

In high-yield debt, we think European high-yield corporate bonds are in good health and show that cash balances for European companies have grown this year at the fastest rate since 2009, as management teams remain conservative. We are encouraged that European lending conditions are the most positive since 2007, as high-yield typically performs well in this environment. There is a risk that volatility in rates markets will have a knock-on effect in the real economy, though we point out that the spread between government bonds and lending rates in the real economy looks large by historical standards. We remain constructive on European and U.S. high-yield.

Nick Gartside is the international chief investment officer of fixed income and co-manager of multisector fixed-income products at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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