In our recent market outlook, we emphasized the objective that we do not aim to track a benchmark in the traditional sense and that our primary concern was that the portfolio should meet every investor’s desire to preserve capital. With markets remaining uncertain, we have continued to maintain a defensive approach by being biased towards bond funds and mixed asset funds (which have also been biased towards bonds). This approach has kept growth on our portfolios stable.

Determining an accurate outlook for the financial markets is never an easy task, however the 2013 bond market outlook is even more challenging than usual. While nearly all of the factors that helped bond market performance in the past two years remain firmly in place, bond yields are at extremely low levels compared to history. This indicates that yields have less room to fall (and by extension, for prices to rise) than was the case one or two years ago. At the same time, it leaves greater latitude for yields to rise which would in turn cause prices to fall if one or more elements of the fundamental backdrop were to change. The bond markets are therefore looking at one of two scenarios:

• The investment environment improves or stays the same. In this case, the overall bond market would likely deliver returns within one to two percentage points of its yield in 2013.
• The investment environment takes a turn for the worse. Under this scenario, bonds could have significant downside.

However, the primary question is determining the probabilities of these two outcomes. Though the first scenario is more likely than the second, investors will still need to be cautious that the balance of risk and reward now is much less favorable compared to previous years. Compared to equities, bonds can continue to provide safety, diversification, and modest levels of income – however the returns will not be the same as they were during the 2011-2012 periods.

In the last quarter of 2012, “iShares iBoxx $ InvesTop Investment Grade Corp. Bond Fund” offered a 30-day SEC annualized yield of 2.75%, while the largest high yield ETF, iShares iBoxx $ High Yield Corporate Bond Fund (HYG) yielded 5.76%. Both were still well above the 1.61% yield available on the 10-year U.S. Treasury note on that date. However, both are also near the low end of the historical range.

At the same period, the 30-day SEC yield on the iShares JPMorgan USD Emerging Markets Bond ETF had fallen to 3.3%, near the lowest in the history of the ETF. This indicates that investors aren’t getting paid nearly as much for the risks as they were one, two, or three years ago.

Although the risk-reward tradeoff has become less attractive, there are still a number of important positive factors that could hold back the major meltdown in the bond markets:

• The U.S Federal Reserve has mentioned that it will not consider raising interest rates at least until unemployment reduces to 6.5% or inflation climbs beyond 2.5%, together with this the Fed is still employing its quantitative easing program. With the efforts from the Federal Reserve, seeing a major sell-off in US Treasuries is unlikely, except if we experience a significant decrease in unemployment figures or an increase in inflation, which will then benefit other asset classes.
• Inflation remains low and we currently do not foresee any concern for inflation in the near term though there may be fears that the stimulative efforts from the Fed may increase prices.
• Overall economic growth remains sluggish, and with higher taxes due for 2013, it is unlikely that it will grow above the 1-2% range. Should the economy experience stronger growth, the central bank will more likely raise interest rates which will hurt bond prices.
• The “spread sectors” of the bond market – in other words, the non-Treasury segments that trade based on their “yield spread” (or advantage) over Treasuries – should continue to find support from investors’ search for higher-yielding alternatives to the safer areas of the market. This has been – and given the Fed’s low-rate policy – a positive factor supporting corporate, high yield, and emerging market bonds. At the same time, municipal bonds are likely to perform well in any environment since taxes are likely to go up no matter what the final outcome.

Though this factors may back the bond sector, there are several significant concerns that may prove otherwise:

• Though the current level of inflation may be low; central banks across the globe have been pumping money into the global financial system in recent years. The simple reason this could cause inflation is that there is now more money in the system with the same amount of goods and services to purchase – which technically will drive prices up. As mentioned above, this is yet to happen due to sluggish growth; however when it does, Treasury yields will begin to climb in anticipation of tighter Fed policy, and the bull market in bonds will likely unravel.
• The so called fiscal cliff has been resolved; however U.S. lawmakers still have to vote to raise the debt ceiling. Investors expect the issue to be resolved, as usual at the last minute, and any failure to do so would cause higher-risk assets to decline in price. But it would likely boost Treasuries and Treasury Inflation-Protected Securities (TIPS) while causing corporate, high yield, and emerging market bonds to lose ground. We should see how this issue gets resolved by the first quarter.
• Besides this, there may be other unforeseen risk factors lingering around the bond sector that may cause a major pullback. Examples would be a sudden and surprising deterioration of the Chinese economy, a worst-case scenario emerging from the European debt crisis (such as a collapse of the Eurozone), or a severe downturn in the global equity markets. Typically, these types of issues benefit U.S. Treasuries but weigh heavily on higher-risk market segments such as high yield and emerging market bonds.

Both corporate and high yield bonds produced average annual total returns of 9.30% and 12.30%, respectively. With such high returns already in the rear-view mirror, it’s highly unlikely that corporate and high yield bonds can continue to deliver similarly robust performances in 2013. In addition, week-to-week volatility is likely to rise – a contrast from the relatively steady upward trend that characterized 2012.

As for emerging market bonds, even though the fundamentals in these regions are much stronger now than they were 10 or 15 years ago, emerging debt is still very sensitive to developments in the broader world economy. During the times when investors lose their appetite for risk, emerging market bonds will almost undoubtedly underperform. Factors that could derail the asset class in the year ahead include a worsening of the economic slowdown in the United States and/or China, a resurgence of the European debt crisis, or conflict in the Middle East, not to mention risks as yet unknown.

In recent years, we have seen a significant amount of cash moving out of stocks and into the bond sector. Yields are presently so low that it has now become technically impossible for bonds to replicate recent returns. Stocks currently offer investors attractive dividends and potential for capital gain, and if the economy sees an improvement, we will see capital being redirected from bonds to equities.

Following expectations of continued low yields, higher volatility and limited growth on the bonds, we have crystalized gains that were made throughout our bond funds. Proceeds from the sales will be reallocated into various mixed asset funds which has exposure to equities, bonds, currencies and are not limited to remain invested in a specific asset class.

I hope that you enjoyed reading

Warm regards

Stuart Yeomans 

CEO

Farringdon Group

Kuala Lumpur : Malaysia