Risk-takers get a wake-up call

The performance of the bond markets in November suggests the risk takers who have profited during the course of the year are ready to lock in profits and call it a day. The news that Dubai World--the state-owned investment and development holding company--requested a six-month standstill on its debt rattled the markets and was a rude wake-up call for bond investors. This is a not-so-subtle reminder that the default of a major borrower is still part of the equation.

The US and European markets also showed evidence of the risk unwind as the rally in spread product has slowed to a crawl. Interest rates in the US continue to trend lower, leading to positive total returns in most sectors. The Morningstar US Core Bond Index, our broadest measure of the US bond markets (includes government-, corporate-, and mortgage-backed bonds), rose 1.4% in November and is up 6.5% year to date.

Still the safe haven
With headwinds of a declining currency, record volume of borrowings, historically low yields, and a qualifying statement from the Federal Reserve, US Treasuries remain resilient to rising interest rates. The Federal Open Market Committee qualified its commitment to low interest rates in previous statements saying the commitment to "exceptionally low" interest rates depends on "low rates of resource utilisation, subdued inflation trends, and stable inflation expectations." Foreign buying continues unabated, and a good share of the risk profit-taking is getting parked at the risk-free rate. The demand was sufficient to take the two-year yield to its lowest level of the year and the three-month bill yield to negative territory. The Morningstar US Treasury Index posted its second best month of the year, rising 1.4% in November.

Treasury Inflation Protection Securities (TIPS) continue to find strong demand and have out-paced nominal Treasuries every month since March. The Morningstar TIPS index rose 2.7% in November and is up 13.3% on the year. The Treasury Department announced a reintroduction of the 30-year TIPS, with the first auction to occur in February 2010, and the immediate discontinuation of 20-year TIPS auctions. In the statement, the Treasury emphasised its commitment to the programme and its plans to gradually increase TIPS issuance. Its intentions are to "potentially improve liquidity... extend the average maturity of the portfolio, and better capture the premium associated with inflation protection."

Sovereign credit risk persists
In November European interest rates trended lower and in line with those of the US. The Morningstar Euro Government Index rose 0.8% while the UK Treasury Index rose 1%. The demand for inflation protection in the US is being mirrored in Europe where the TIPS indices are substantially outperforming their nominal counterpart. Aided by the decline in the currency, the Morningstar Global ex-US Government Bond Index, measured in unhedged US dollars, rose 3.8% in November and 15.3% year to date. The Index hedged into US dollars rose only 4.3% year to date.

This year and last year have illustrated more than in the past that sovereign credit risk matters. Prior to the adoption of the euro, European sovereign investors' primary risk was foreign exchange rates, which typically overwhelmed both credit and duration risk. From 2000 to 2007, the greatest annual difference in total return between the Morningstar Euro Government Index country components was 3.2% in 2001. In 2008, as investors were willing to pay significant premium for quality, the difference spiked to 11% (Germany led the way with a return of 12.2% versus Greece, which trailed with a return of 1.2%); the difference year to date in 2009 has been 5.5% (Italy has been the leading performer--rising 8.4%--while Ireland is at the bottom with 2.9%). Although the markets are returning to normalcy, sovereign credit risk persists even between those with a common currency. Investors in euro-denominated sovereign funds need to be cognisant of country allocation.

US credit rally runs out of gas
Evidence of profit-taking in the more risky assets (emerging-market and high-yield bonds), is also evident in the investment grade arena. The yield premium on the Morningstar US Corporate Index was unchanged in November at 1.9%. The yield dropped 20 basis points to just more than 4%. Investors in the sector, only as recently as March, were gathering US corporate assets at an average yield of more than 7%. The finance sector that had been closing the gap created from the financial crisis relative to nonfinancials also stalled. Nonsystematic risks for the financial names persist. Lawmakers' and regulators' actions, for better or worse, are a growing part of the prevailing risk and should get scrutiny equal to that of simple credit worthiness.