Asset managers plan to lighten up on their sovereign bond holdings relative to benchmarks by the end of 2010, according to a bfinance survey of asset managers with almost €1tr in AUM. Asked where they stand compared to their bond benchmark, 28% report they are slightly overweight and 32% slightly under. Asked where they expect to be on December 31, 2010, only 5% expect to be a little overweight while 55% are aiming to be slightly under. As the two charts below indicate, not a single fund reported strong overweight in “high-risk” sovereign bonds. The possibility of a sovereign debt default was on the rise in early May when Greece crystallised concerns about growing public deficits in a number of European countries, raising fears of a domino effect throughout the financial system.     

click to enlarge

source: bfinance

We also asked survey participants to comment on the biggest risk they face in the coming six months. Time and again, they note the impact of Europe’s sovereign funding crisis. “The impact of the Greek crisis spreading to Italy, Spain, Ireland and Portugal, then hitting the rest of Europe with sledgehammer force is particularly worrisome,” notes one respondent. “Credit contagion in the banking sector in Portugal, Italy, Greece and Spain is the biggest risk in the coming six months,” notes another.   

click to enlarge

source: bfinance

The refuge appeal of German bunds and US Treasuries, however, remains strong. Bill Gross, who manages the world’s largest bond fund at Pacific Investment Management Company (PIMCO), is overweight US government-related debt, which is at the highest level in six months. As sovereigns along Europe’s southern periphery crashed, German bunds and US Treasuries rallied, sending yields lower. German 10-year bunds are expected to have among the lowest yields by year end (2.84% on average). Japan is at the low end (1.37% on average) while Greek sovereigns are expected to yield (8.18%), followed by Spain (4.70%), UK (3.71%) and US (3.56%). At the same time, PIMCO reduced its holdings of non-US developed debt (such as European debt) to 6% from 13%.  

A separate pension fund survey bfinance conducted last month shows pension schemes with a three-year horizon intend to increase their target allocation to bonds. This is not surprising, given pension funds’ long-term liability matching needs. Results of the asset manager survey are more likely to reflect shorter-term, tactical views. Among the respondents are alternative funds, including FoHFs and a tactical asset-allocation fund. We also ask the asset managers to forecast spread levels of corporate and investment-grade bonds in the US and Europe. The results point to spread compression by year end. In the investment-grade category, the surveyed managers see a higher level of compression (58bps) in Europe than in the US (14.5bps). In the high yield category, corporate spreads in Europe are expected to come in 97bps compared to 121bps in the US. “There is increasing evidence of a broadening out of the recovery,” notes one respondent. “Corporate results came in far better than expected in terms of bottom line, revenue and margins.” 

The primary catalyst the managers cite for spread compression is economic recovery. They reserve their lowest growth forecasts for the Eurozone, followed by the UK. “Within fixed-income, we are cautious on sectors that are exposed to sovereign risk in Europe,” notes one manager. “This translates into underweighting financials in European peripheral countries and the UK.” The outlook for inflation is also lower in Europe (1.1% in 2010). Given this backdrop, 10-year German bunds are expected to end the year at 2.84%, the second lowest yield after Japan. 

click to enlarge 2-year sovereign bond-yields

source: bfinance

click to enlarge 10-year sovereign bond-yields

source: bfinance

click to enlarge asset allocation spread

source: bfinance

Short-term equity rally to fizzle in the New Year 

Given the higher growth prospects in the US and the shift in sentiment in favour of the dollar, the surveyed managers expect the S&P to advance 17% in the next six months, higher than the European indices. When the survey questions were sent in June, the S&P stood at 1,087. The respondents expect the S&P to finish the year at 1,276. They see the FTSE100 and Eurostoxx each advancing 8%, while the Emerging Market MSCI is expected to rise 14% in the same period. “A stronger USD has a positive impact on our portfolios,” notes one manager. “During the last three months we have increased the US dollar assets in our portfolios.” The drop in the euro has also strengthened the profit outlook for Europe’s export-led growth industries. “Eurozone companies benefit from the weakened euro,” notes one manager. “This means overweighting strong export-oriented European industrial groups.” Given their positive equity forecasts, 50% of asset managers say they will move to a light overweight position by the end of the year compared to 38% who are currently light overweight. Eleven percent of respondents are currently strong underweight equity, while not one is in this category by the end of the year. “Valuation in equities is attractive relative to the fixed-income sector,” notes one respondent. The managers expect the equity market rally to come to a halt in the first half of 2011, with their June 2011 equity index forecasts largely flat from the end of this year.  

Similar to the findings of our pension fund survey, asset managers do not seem particularly alarmed about inflation or a sharp rise in interest rates. Most of the concern in the fixed-income category is reserved for higher-risk sovereigns, while sentiment for safe-haven sovereigns is strong. Finally, the respondents expect to commit more to alternatives by year end, providing further confirmation of what we saw in our pension fund survey. When we asked managers where they see opportunity in the market, one manager cited commodities: “The cyclical forces at a global scale support the commodity sector. Commodity and metal prices in particular benefit from a recovery in industrial production that is not likely to peak well into the second half of this year.”

click to enlarge indexes forecasts

source: bfinance

click to enlarge foreign exchange forecasts

source: bfinance

click to enlarge growth forecasts

source: bfinance

click to enlarge inflation forecasts

source: bfinance

VB and GC