A chorus of voices has recently become increasingly loud, signing from the same hymn sheet of 'It's all over for bonds'. The lyrics are seductive, the tempo attractive, but there is something definitely out of tune with the story.
The bond market is a function of two key variables that drive most of the returns - the risk free yield curve and the credit spread.
For our market, the risk free curve is deemed to be the US Treasury curve. Purists may argue that the US curve is no longer risk free with the US having lost its coveted 'triple A' moniker last year, but the fact is that US dollar credit is priced off the US curve and there is no credible alternative. Every time MENA-based entities issue in US dollars, the market will price off the US dollar curve.
So what is the outlook for the US curve?
Take a look at the 100-year chart of US Treasuries. Those who say it is all over tend to look at this as the defining chart. 'Rates have never been lower,' they cry, 'the only way is up.' But the experience of Japan in the late 1990s has taught me that just because something is expensive doesn't mean it will become cheaper. What is missing is a catalyst and I would argue that we have just had the reverse.
The yield curve is the term structure of interest rates and as such mathematically begins with short rates. The very same short rates that the Federal Reserve has just told us will not be moving until at least 2015. The short end is therefore effectively pinned at close to zero.
The same Fed has also told us that it is going to continue to pump money into the US until it sees signs of growth and employment (one of the last things to move). All well and good, but no one seems to have told the banks what to do with the money, so in the absence of a vibrant economy and faced with corporates who do not want to borrow, these funds find their way into financial markets (the money multiplier being currently broken).
So the Fed is buying the curve and the money that they put into the hands of the holders of US debt also buy the curve, thus squeezing yields lower and forcing others out of lower yielding assets and into higher yielding assets. Post the last Fed announcement of QE 'Infinity', Treasuries have actually rallied. The Japanese experience tells us that rates can, and will, stay low for much longer than people expect.
Credit spreads have different drivers but are none the less linked by global capital flows and the search for yield. MENA region bonds have a number of things going for them today:
1. Abundant global liquidity.
2. Abundant local liquidity - driven in the main by conservative fiscal assumptions as to the oil price in 2012 that are at odds with the far higher actual outcome. This has left the regional economy in a relatively healthy position.
3. Extensive infrastructure and social spending. As economies in the region continue to develop their infrastructure and continue to respond to the social needs of their domestic populations, spending remains robust. The government's involvement in the regional economy allows the region to stand out from the competition (Europe and the US), and allows smart managers to allocate capital to a region that is simply doing something different.
4. We are still cheap. As I have been saying for a number of years now, market segmentation and a fundamental misunderstanding of people who do not live in the region keep our credit on the cheap side. It started with the hangover from the 2008 crisis which took a while to dissipate (and in some credits still hasn't, providing opportunities), and continues with the lack of understanding about the strategic nature of certain credits to the underlying economy and the support that they are likely to receive in the event of a problem.
In short, there is still much to play for in MENA region bonds. The orchestra tuned up long ago and we are in the second or perhaps third movement of the symphony. The market is still poorly understood, under-allocated globally, and inefficiently researched. Put that together and it shows us that there is still alpha to be captured by managers who are resourced, on the ground, and know their markets and their craft.
The symphony shows no sign of ending yet.
Mark Watts, CFA, is the head of fixed income at National Bank of Abu Dhabi-Asset Management Group. The views expressed are his own and not those of the bank or of Zawya.
© Zawya 2012
