Global T ti l Gl b l Tactical Asset All ti A t Allocation

GTAA
Fixed Income
Fourth Quarter
September 20th , 2010 Damien Cleusix damien@clue6.com d i @ l 6
Clue6 Fourth Quarter 2010

Executive Summary
Fixed Income

US Government bonds are not a bubble. They are probably not a good B&H investment but they are behaving rationally. They correlation with nominal GDP growth will continue to rise as long as the economy will be in a balance sheet recession with d fl i showing i ugly f i h deflation h i its l face on every slowdown... l d Yields have resumed their downtrends as expected when the leading indicators started to soften. As with equities, the business cycle will rule. On the inflation/deflation debate we did not have the feared short-term inflation scare that would pave the way to a new wave of deflation and, further down the road, inflation or more. Emerging market are experiencing one (food price inflation and its social consequences) and, as in 2008, will force authorities to tighten precisely at the wrong time. Careful analysis of government and Central Banks words and acts will be needed as there remain a risk that they will try to inflate the problems away more quickly than anticipated. QE2 might be soon a reality and while its effectiveness in pushing rate lower is still to be proved, if it does it could be the trigger to a new round of competitive devaluation around the world (which ironically will push US government bond yields lower and ). On the potential of QE2 to solve the challenge facing the US economy (and similar policies elsewhere) our response is a categorical no for economies in the middle of a balance sheet recession. Fiscal policies yes, monetary policies no (but one has to remember that the Fed, when it guaranteed and bought GSE MBS, was in fact making an unconstitutional fiscal policy, not a monetary one ) one) The fact that AUSTERITY is on every politicians mouth seems to strengthen the case for deflation now and inflation laterin desperation. Corporate and Emerging market bonds spreads have contracted in the past few weeks. Dont be fooled, while spreads
Clue6 Fourth Quarter 2010

Executive Summary

seems to have some room to fall further, absolute yields are almost at historic lows. Both high yield and emerging markets bonds are yielding less today than at the high of the credit bubble in 2007. Beware Sentiment analysis is inconclusive for government bonds after having showed signs of short-term excessive optimism in y g g g p August. While we are seeing excess on the corporate and sovereign high yield (not so high yield) space. On the liquidity side, banks and public demand should be more than sufficient to absorb public issuance, for now. Refinancing needs at the high yield corporate, banks and emerging markets side are likely to pose a much greater risk in the future but b companies/countries h / i / i have/are profiting f fi i from the current i h investors thirst f yields to refinance and l hi for i ld fi d lengthen the h h duration of their repayment schedule. While many emerging markets are in much better shape than 10-15 years ago, they still remain dependant on flows from the US, Europe and Japan. Furthermore never underestimate the power of crowd dynamic in this area of the market. Stress in Eastern Europe or inside the EU will have dramatic domino effects especially when, as we have documented in the past more than 70% of the loans to emerging markets have been made by European financial institutions past, institutions. This will provide a fantastic buying opportunities. If you have to be long or if you can do relative value, favor operating leveraged against financially leveraged countries. Seasonality is still favorable for government bonds and negative for more risky bonds. The trend of the US, Euro and UK government bonds markets is unequivocally down (for yields). Yields have pulled back to well defined resistances where we would be buyer on weakness (yield weakness) or on further strength. We are seller of covered upside price volatility on excessive price strength. d id i l ili i i h Corporate and emerging market bonds trends are rising. We prefer to be on the sideline. Remember that it is sometimes better to be out of the market wishing to be in than in the market wishing to be out. Sometimes less yield is better.
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Bonds: Valuations
Chart 1 GMO 7 Years Return Forecast (July)

Source: GMO

We still do not think that US government bonds are a bubble. They are clearly a poor long-term investment (Chart 1) but they are behaving rationally given the nominal growth prospects. Yields will continue to follow the ebb and flows of leading indicators and 10 years yield will decline much below 2% before we have a real inflation scarce. There will be a time when one will have to worry about inflation as government spending continue to grow and new stimuli will have to be voted in the next few years but we are still in a deflationary environment whose existence has now become apparent even if commodities have yet to fall. The huge pick up in the monetary base has not resulted in an increase of credit (money multiplier collapsing). Capacity utilization is low, wages should continue to have a moderating effect,

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Fourth Quarter 2010

Bonds: Default History

Chart 2 Moodys US Investment Grade default Rate Table 1 Investment Grade 5 Years Default Priced by the CDS Market

Source: Bloomberg, Clue6

Source: Moodys, Clue6

Investment Grade default risk priced by the CDS market is still high if one look at the historical 5 years cumulative default. 103 bps with a 30% recovery rate imply a 6.8% 5 years cumulative default which is higher than the 4.5% reached in the 30's. But when one look at the level of indebtedness and the fact that we might experience (this is our main scenario as you know) some quarters of negative NOMINAL growth in the 3-18 month to come, there is room for yields to widen a bit. Note also that leases will have to be capitalized in the balance sheet according to a new FASB proposal. This will increase, substantially for some sectors, their absolute and relative (debt/equity) indebtedness. Lastly if one look at absolute yields, there is nothing to be exited about. We prefer to buy high quality high dividend paying stocks. You have an implicit inflation hedge and the capital gains prospects are larger
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Bonds: Default History

Chart 3 Moodys US Speculative Grade default Rate Table 2 High Yield 5 Years Default Priced by the CDS Market

Source: Bloomberg, Clue6

Source: Moodys, Clue6

High yield and emerging markets default risk priced by the CDS market has decreased substantially. 544 bps (for the US high yield bonds) with a 30% recovery rate i l a 31 2% 5 years cumulative d f l which i l ih imply 31.2% l i default hi h is lower that the 2 previous peaks ( h h i k (spreads would need to widen b more d ld d id by than 100 bps) and much lower than the peak in the 30s (spreads would need to widen by more than 400 bps). The problems identified for investment grade bonds apply here too. And A d

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Fourth Quarter 2010

Bonds: Default History

Source: Moodys, Clue6

One should keep in mind that the percentage of high yield bonds issued near the end of the credit bubble in 2007 which were rated Caa and below was the highest in history. Those bonds have a very high default propensity (not that the chart above is not 5 years cumulative default as the previous ones but yearly default). This time it wont be different.

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Fourth Quarter 2010

Bonds: Fundamentals
Chart 4 Developed Economies Nominal Interest Rates and Growth Rate Relationship Chart 5 Developing Economies Nominal Interest Rates and Growth Rate Relationship

Source: UBS

Source: UBS

We have demonstrated in the past that the US 10 years government bond yields levels and change have a high correlation with the GDP nominal growth. i l h On the charts above one can see that it is true for developed economies in general (Chart 4) but it is not the case for developing economies (Chart 5). The graphs are calculated comparing 20 years nominal growth rate to the 20 years average nominal rates.

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Fourth Quarter 2010

Bonds: Fundamentals
Chart 6 Japan Average Nominal Growth and 10 Years Government Bond Yield Chart 7 Japan OECD Trend Restored Leading Indicator and 10 Years Government Bond Yield

Source: BOJ, Clue6

Source: OECD, Clue6

On chart 6 one can see the relationships between Japanese nominal GDP growth and nominal 10 years yields. Note the downside acceleration when YoY growth move below 0. The lower the average nominal growth, the more sensible yields become to the macro cycle. Ten years yield are topping at the same time as leading indicators (chart 7)

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Fourth Quarter 2010

Bonds: Fundamentals
Chart 8 US Average Nominal Growth and 10 Years Government Bond Yield Chart 9 US OECD Trend Restored Leading Indicator and 10 Years Government Bond

Source: Federal Reserve, Clue6

Source: OECD, Clue6

And here is the same graphs for the US. If those were the only things to think about, forecast would almost be easy but you have to add the current real debt burden and the banking crisis/debt crisis historical relationships which should eventually lead to a rapid structural move up in yields (our central case is that this is not yet something people should worry about for the US at least)

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Fourth Quarter 2010

Bonds: Fundamentals
Table 3 Fiscal Imbalance as a Percentage of GDP (2004) Chart 10 US Government Debt to GDP Ratio

10

Source: Measuring the Unfunded Obligations of European Countries J. Gokhale

Source: Federal Reserve, Clue6

It is not the towering sail, but the unseen wind that moves the ship. Dont be fooled, when the public realize that they will never get what they have been promised, behaviors will change and this is not going to be good for growth and risky assets. On chart 10 one can see a debt to GDP ratio for the US including state and local debt and GSE debt (if you want to know why the GSE are included, included we would advise to read the Christmas 2009 Treasury announcement on Fannie Mae and Freddie Mac) We are above 100% Mac) 100%.

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Fourth Quarter 2010

Bonds: Fundamentals

11

Source: M. Reinhart and K. Rogoff

We have insisted a lot in the recent past on the prospect of sovereign distress down the road and it seems that the markets have finally taken note. Banking crisis are expected to be followed by debt crisis with a lag as the fiscal costs ultimately overwhelm the capacity of affected countries to repay their foreign owned debt. So be prepared for sovereign stress to continue and dont chase yields where risks are too high. The most successful investors are those who do not lose money.
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Bonds: Fundamentals
Chart 11 Greece CDS Implied Default Probability (assuming 60%
recovery rate)

12
Chart 12 Spain CDS Implied Default Probability
(assuming 60% recovery rate)

Source: Bloomberg, Clue6 Idea: P. Schwartz

Source: Bloomberg, Clue6

Among the developed economies, the day of reckoning will hit Europe first (Japan should be monitored attentively too). As A one can see, th E the European Fi Financial St bilit F ilit announcement h d i l Stability Facility t has decreased th market priced probability of a d f lt i th d the k t i d b bilit f default in the short-term for countries like Greece and Spain (Chart 11-12) but the long-term probability have increased. As said when the announcement was made, we find it easy to promise money to bail out a country when one believe that we will never have to bail one out but what happen if countries have to be bailed out (Greece is manageable but Spain isnt, Greece, Portugal and Ireland together barely and who really think the dominos will stop to fall ) The end result is a plunging Euro (and then a disappearing one) debt restructuration and radically fall). one), lower standard of living in most countries (and dont expect the masses to stay quite)
Clue6 Fourth Quarter 2010

Bonds: Inflation

13

Source: Federal Reserve, Clue6 Idea: J. Hussman

While, as you know, we are not worried by inflation in the short-term (with the exception of some emerging markets and food in particular). We will have an inflation p problem down the road Mainstream economists and Wall Street analysts hold that inflation is caused by monetary policy, and specifically by excessive money creation. .. To understand inflation, it helps to know a little bit about marginal utility. . So as you increase the availability of a good, the marginal utility the value you place on an additional unit declines Exactly the same holds true for money itself. If you hold a dollar in your wallet, you might be giving up some potential interest earnings, but you're willing to hold it anyway because that dollar of currency provides certain usefulness in terms of making day-to-day transactions and so forth. If that dollar is held as reserves against checking accounts at a bank, that dollar is implicitly providing a certain amount of banking services. So a dollar bill has a certain amount of marginal utility, by virtue of legal factors like reserve requirements on checking accounts, and convenience factors like the ability to buy a nutty sundae with cash ... As a result, the prices of various goods and services in the economy, in terms of dollars, will reflect the ratios of marginal utilities between stuff and money In short, inflation results from an increase in the marginal utility of goods and services, relative to the marginal utility of money. It can reflect supply constraints, unsatisfied demand, excessive growth of government liabilities, or a reduction in the willingness of people to hold those liabilities The importance of fiscal policy in determining inflation is immediately apparent if we think in terms of the full or general equilibrium imposed by a government budget constraint. In both cases, regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and bonds services, and has issued a piece of paper a government liability in return, which has to be held by somebody This is important, because it means that the primary determinant of inflation is not monetary policy but fiscal policy. (J. Hussman)
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Bonds: Sentiment
Chart 13 TLT and Conference Board Interest Rate Survey Chart 14 Strategists Bond Allocation

14

Source: Conference Board, Clue6

Source: Bloomberg, Clue6

A net 30% of people surveyed by The Conference Board are expecting rates to rise in the next 12 months (Chart 13). As one can see they were most bullish at the start and end of 2008 just when yields were making lows. We are still far away from levels where we would rate optimism exuberant Strategists have sharply lowered their recommended allocation to bonds since the start of 2009 (Chart 14) but we are probably near the bottom of a new range.

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Fourth Quarter 2010

Bonds: Sentiment
Chart 15 ML Fund Managers Survey on US Bonds Chart 16 JP Morgan Treasury Investor all Clients Net Long Survey

15

Source: Merrill Lynch

Source: Bloomberg, Clue6

A net 25% of managers pooled by Merrill Lynch are underweight bonds (Chart 15) and more than 60% are expecting long-term rates to be higher in 12 months months. JP Morgan Treasury Investor Sentiment all Clients Net long survey (% net long - % net short) is just shy of 10 (Chart 16). Note that the clients surveyed have been more often right than wrong at turning points

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Fourth Quarter 2010

Bonds: Sentiment
Chart 17 US Long Bond Future and its Put Call Ratio Chart 18 TLT and Rydex Short US Government Bonds Funds Asset

16

Source: Bloomberg, Clue6

Source: Rydex, Clue6

The Long Bond future PC ratio is low and thus not as supportive as it was in the past few months (Chart 17). It should even be rated as bearish . Assets in the Rydex Short Government Bond funds have decreased substantially but this is due to the underlying performance rather than net funds selling (Chart 18). Note that the last time we really had net selling despite yields falling was at the 2007 ten years treasury yields top.

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Fourth Quarter 2010

Bonds: Sentiment
Chart 19 TLT Shares Outstandings Chart 20 HYG Shares Outstandings

17

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

TLT shares outstanding have been rising very rapidly during the recent correction (chart 19). Similar frantic buying have been usually g g y p y g ( ) y g y witnessed at bottoms. HYG shares outstanding have also been increasing at a very rapid pace (chart 20). They have not declined during the last correction as they have in the past. Feels like too much money pouring in and the rest of our analysis is giving the same impression By the way corporation have noticed and are giving investor what they want paper. g g y p p

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Fourth Quarter 2010

Bonds: Sentiment
Chart 21 US 10 Years Treasury Yields and Tbonds Commercials and Non Reportable Net Future Position Chart 22 US 10 Years Treasury Yields and 10 Years Tresurys Commercials and Non Reportable Net Future Position

18

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

Commercials are now net shorts Tbonds for the first time since the middle of 2008 (Chart 21) while non-reportables are net long. Commercials have historically been the smart money but they can be wrong as they were between 1997 1999 We will start to worry if the price trend deteriorate 1997-1999. and the commercials/non-reportables configuration remains the same. Both commercials and Non Reportable have sharply decreased their net position on the 10 years treasury(Chart 22). Commericals remain net long while non-reportables have switched to a net short position. Yields have had a tendency to start meaningful decline when both have switched from a net long to net short position and the reverse is true at bottoms bottoms.

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Fourth Quarter 2010

Bonds: Sentiment Smart Money

Chart 23 US Government Bonds 10 + Total Return and WasatchWasatch Hoisington US Treasury Beta Exposure Chart 24 ML High Yield Master II and Loomis Sayles Institutional High Income Beta Exposure

19

Source: Clue6

Source: Clue6

There are many good bond investors but there are 2 which consistency has always fascinated us. On Chart 23 one can see that V. Hoisington has decreased its exposure to the US long bonds on the recent rally. It still remains at the top of its pre2009 range. D. Fuss has been a buyer on the most recent decline (Chart 24). Its exposure is in the middle to upper of the historical range.

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Fourth Quarter 2010

Bonds: Liquidity
Chart 25 Government Bonds as a Percentage of Commercial Banks Total Assets Chart 26 10 Years Treasury and Yield Curve

20

Source: Federal Reserve, Clue6

Source: Bloomberg, Clue6

There are many investors worrying about who will be left buying the bonds issued by the US Treasury (and others finance ministries around the world). world) This could become a problem down the road (and in the medium term when/if private credit demand picks up as the private debts stock is medium-term 2.5x the public one in the US) but there are potentially huge pool of demand. Commercial banks will probably increase dramatically their Treasury investment (Chart 25), both because they will have to (new regulations) and because they will us the carry between long and short rate to build up capital at low risks (Chart 26). This is what happened in Japan and in other countries (US included) in past similar configuration.
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Bonds: Liquidity
Chart 27 US Households Net Buying of Treasuries Chart 28 ICI Bond Mutual Fund Assets and Net Cash Flow

21

Source: Federal Reserve, Clue6

Source: ICI, Clue6

Households will also continue to reallocate toward fixed income investments as we demonstrated in 2007 (Chart 27) Only 9-10% of their assets are in fixed income securities Retiring boomers will see more attraction in stable cash flows as opposed to capital gains (and they haven't made a dime on this in the past 12 years...) Fixed income mutual fund buying (Chart 28) has been concentrated in the corporate bonds mutual funds demand will slowly be moving toward government bonds now that yields have been rising and corporate spreads declined

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Fourth Quarter 2010

Bonds: Liquidity

22

Source: Mirae Asset Management

If we take the 1989-1994 cycle has a model, the private domestic sector should buy usd 6.3 tn. Until the end of 2013, more than the usd 5.5 tn. budget deficit projected and we believe that they will buy substantially more Something to keep an eye on in the short/medium-term is a potential resurgence of private sector credit demand. The stock private sector credit is 2 5 times larger than government one and this could crowd out some demand for govies 2.5 crowd-out govies

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Fourth Quarter 2010

Bonds: Liquidity
Chart 29 10 Years Treasuries and Bids Chart 30 US TIC Data

23

Source: Clue6

Source: Bloomberg, Clue6

What about foreign demand. When buying treasury bonds, foreigners have four main variables to consider. First the level of the yields, then the relative valuation of the USD, the inflation prospects y g y , g y , , p p and finally the alternatives. US long yields are higher than in Europe and Japan while the currency is significantly undervalued. With regard to the inflation variable The Fed has been somehow more aggressive than the ECB and the treasuries has put a lot of guarantees everywhere which are likely to end up being very costly but the next phase of the economic stress might be centered in Europe and as such the ECB will have to be aggressive too. Remain the alternatives. Seems that there will be less concurrence from European sovereign bonds in the medium-term The last alternative is the creation of larger bond markets in various emerging market regions this will happen but slowly so no real influence for now g g g g pp y Note that foreigners have started to buy corporate and Agency bonds again (Chart 30). Clue6 Fourth Quarter 2010

Bonds: Liquidity
Table 4 Bonds Funds Net Flows Chart 31 Bonds Funds Net Flows QTD

24

Source: BoA, Lipper/AMG, Clue6

Source: BoA, Lipper/AMG, Clue6

Looking t t inflows i t b d f d one can see th t f i b d remain very popular (t bl 4 and Ch t 31) ( th sign of extreme L ki at net i fl into bond funds, that foreign bonds i l (table d Chart (another i f t negativism toward the USD).

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Fourth Quarter 2010

Bonds: Liquidity Refinancing

Chart 32 US High Yield and Leveraged Loans Maturity Schedule Chart 33 EUR High Yield and Leveraged Loans Maturity Schedule

25

Source: Barclays

Source: Barclays

We have been talking a lot about the refinancing problematic since last autumn It is going to be HUGE. Sovereign, high yield corporate g gp g g g , g y p bonds, leveraged loans (Chart 32 and 33), Banks have also huge refinancing ahead and they have an historic low average maturity for their debt. European banks needs more than eur 700 bio. by the end of 2013 to roll over and pay interest on their debt . What if they are starved of short-term funding Basel III was a relief as required coverage ratios were below the lowest forecasts (a relief for banks but not for tax payers down the road). q g ( p y )

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Fourth Quarter 2010

Bonds: Liquidity Refinancing

Chart 34 US High Yield Bond Maturity Schedule: Current vs. Historical Chart 35 Leveraged Loan Maturity Schedule: Current vs. Historical

26

Source: ML

Source: ML

We have also noted that the maturity length has been declining in the past 5-6 years, notably in the leveraged loan sector. This can be clearly seen on the chart 34 and 35.

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Fourth Quarter 2010

Bonds: Liquidity Refinancing

Chart 36 CMBS Maturity Schedule

27

Source: Deutsche Bank

And here A d h one can see what CMBS maturities l k lik h t iti look like

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Fourth Quarter 2010

Bonds: Liquidity
Chart 37 US Quarterly High Yield Bond Issuance (US bn.) Chart 38 Emerging Markets Bonds Quarterly Bond Issuance (US bn.)

28

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

But one also has to take into account the huge issuance of fixed income paper which has, as will be shown on next page, been mainly used to refinance existing debt. On Chart 37 and 38 one can see that there is as much junk bonds being sold today as during the heyday of 2007 while emerging markets bonds issuance is making records after record. Our guess is that investors will regret their thirst for yields g g y

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Fourth Quarter 2010

Bonds: Liquidity Refinancing

Chart 39 2010 First Half High Yield Issuance Purpose Chart 40 US High Yield and Leverage Loans Refinancing and Maturity Schedule

29

Source: Moodys

Source: Morgan Stanley

Moodys has estimated that up to 64% of the first quarter high yield issuance (and even more in 2009) has been used to refinance debt and extend maturity ( h 39) d i (chart 39). This has pushed backward the refinancing time bomb we have been discussing in the previous pages (chart 40).

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Fourth Quarter 2010

Bonds: Liquidity Refinancing

Chart 41 Europe Bonds Net Issuance Calendar Chart 42 Eastern Europe External Flows

30

Source: MS Source: IMF

As one can see, the refinancing issue is not limited to corporate but also sovereign bonds. Where will the money come from? We do not know Expect higher real yields, higher spreads and much more bankruptcies than currently discounted by the market. Watch for failed auctions as catalysts. This is going to be THE ISSUE in the next 2-3 years and remember that government can not afford this inevitable crisesWe will have time to write much more about this i i h b hi issue l later

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Fourth Quarter 2010

Bonds: Quantitative Easing 2

Fed buys Treasuries US Back end of the Treasury curve falls Fed MBS holding fall

31

US Dollar falls

US Mortgage prepayment rise if spreads remains constant or fall

Foreign Central banks buy USD to weaken/limit the rise of their own currencies Intervention proceeds invested in Treasuries
Source: Clue6

US Government Yields fall

Gold bugs surely hope the Fed will embark on QE2

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Fourth Quarter 2010

Bonds: Breadth
Chart 43 Investment grade Cumulative Advance-Decline Line Chart 44 High Yields Cumulative Advance-Decline Line

32

Source: MS Source: IMF

The high yield and investment grade bonds US advance-decline line is still in synch with the markets.

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Fourth Quarter 2010

Bonds: Breadth
Chart 45 High Yield Bonds Fosback High-Low Index Chart 46 High Yield Bonds New High as a % of Total

33

Source: MS Source: IMF

We have yet to see dispersion increasing (Chart 45) 45). But note that the high yield indices are making new highs at the same time as the % bonds making new highs is declining (Chart 46). It is hovering just above the 5% zone where high yield bonds indices have tended to suffer.

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Fourth Quarter 2010

Bonds: Seasonality
Chart 47 US Treasury Bonds 7 10years) TR 7-10years) Seasonality (since 1986) Chart 48 US high Yield Bonds TR Seasonality (since 1990)

34

Source: Clue6

Source: Clue6

Government bonds have the inverse seasonal pattern of the stock markets (Chart 47) . High yield bonds seasonality pattern is similar as the stock market (Chart 48).

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Fourth Quarter 2010

Bonds: Intermarket

35

10 Years yield have a tendency to fall when 5 year forward 5 year real yield rise above 2.5%. Well it worked again, like a charm and we are creaping back to those levels The ECRI, other leading indicators and J. Hussman recession models remarks made in the equity section have the opposite implication for bonds. Ceteris paribus government long term bond yields will fall This is expected to be the case in the US at least at least in a first phase but the ceteris long-term fall. US, phase, paribus seems far fetched for Europe, the UK and ultimately Australia.
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Bonds: Demographic
Chart 49 10 Years Treasury Yields and Demography

36

Source: Emphase Finance

We ill i W will write more about this i the f b hi in h future b suffice to say that purely d but ffi h l demographic models are not f hi d l favorable f b d yields bl for bond i ld The proportion of retirees will rise faster than those saving a lot

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Fourth Quarter 2010

Bonds: Graphs
US 10 Years G Y Government B d Yi ld Bond Yield

37

Shoulder Shoulder Shoulder Head Shoulder

Head

There were a lots of talks about a potential inversed Head & Shoulders secular bottom in the 10 years US yield. This was also the case in 2005 . We are still in a secular bull market, make no mistake. There will be time to get structurally bearish but not now

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Fourth Quarter 2010

Bonds: Graphs
US 10 Years Government Bond Yield

38

Ten year yield are pulling back to the 2.8-2.9 resistance where some demand should reappear. While there were many sign of short to medium term excesses in mid-August most have been corrected since. We W are t ti ll b tactically buyer (t (treasury b buyer) on a mover b l 2 65 or on a move t 3 05 3 1 ) below 2.65 to 3.05-3.1.

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Fourth Quarter 2010

Bonds: Graphs
Euro 10 Years G E Y Government B d Yi ld Bond Yield

39

We would avoid European bonds for now. For the pure technician we are at resistance and we would be buyer on a move below 2.35 or in the 2.65-2.8 range.

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Fourth Quarter 2010

Bonds: Graphs
UK 10 Years G Y Government B d Yi ld Bond Yield

40

We have said since 2007 that the UK would face a very serious fiscal crisis which would potentially need the intervention of the IMF. We still believe it. Lets see how it copes with a rapidly falling residential real estate market in the next 6-24 months.

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Fourth Quarter 2010

Bonds: Graphs
iShares iB iSh iBoxx $ High Yield C Hi h Yi ld Corporate B d F d (HYG) Bond Fund

41

Moodys BAA Yields

The trend is up but Do not forget that while spreads have yet to reach historic lows, absolute yields are at secular lows. y y p g y j (p Do you feel you are compensated for the risks? We do not. This can be frustrating to stay out at this juncture but the reward (preserved cash to buy at much wider spreads and fatter yields) is worth the discomfort.
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Bonds: Graphs
iShares JP M iSh Morgan USD E Emerging M k B d F d (EMB) i Markets Bond Fund

42

ML Emerging Markets Sovereign Plus Yields

There will be great opportunities coming but now we want to continue to observe the market from the outside. We know that there will be better opportunities when we hear people talking about the fantastic opportunities in Ghana domestic bonds yielding 5 and something percent. When time comes and the baby is thrown with the bath water we will be heavy buyers as we have sometimes in the past.
Clue6 Fourth Quarter 2010

Bonds: Conclusion

43

US Government bonds are not a bubble. They are probably not a good B&H investment but they are behaving rationally. They correlation with nominal GDP growth will continue to rise as long as the economy will be in a balance sheet recession with deflation showing its ugly face on every slowdown... Yields have resumed their downtrends as expected when the leading indicators started to soften. As with equities, the business cycle will rule. On the inflation/deflation debate we did not have the feared short-term inflation scare that would pave the way to a new wave of deflation and, further down the road, inflation or more. Emerging market are experiencing one (food price inflation and its social consequences) and, as in 2008, will force authorities to tighten precisely at the wrong time time. Careful analysis of government and Central Banks words and acts will be needed as there remain a risk that they will try to inflate the problems away more quickly than anticipated. QE2 might be soon a reality and while its effectiveness in pushing rate lower is still to be proved, if it does it could be the trigger to a new round of competitive devaluation around the world (which ironically will push US government bond yields lower and ). ) On the potential of QE2 to solve the challenge facing the US economy (and similar policies elsewhere) our response is a categorical no for economies in the middle of a balance sheet recession. Fiscal policies yes, monetary policies no (but one has to remember that the Fed, when it guaranteed and bought GSE MBS, was in fact making an unconstitutional fiscal policy, not a monetary one) The fact that AUSTERITY is on every politicians mouth seems to strengthen the case for deflation now and inflation laterin desperation. Corporate and Emerging market bonds spreads have contracted in the past few weeks. Dont be fooled, while spreads seems to have some room to fall further absolute yields are almost at historic lows Both high yield and emerging markets bonds are yielding less further, lows. today than at the high of the credit bubble in 2007. Beware Sentiment analysis is inconclusive for government bonds after having showed signs of short-term excessive optimism in August. While we are seeing excess on the corporate and sovereign high yield (not so high yield) space.

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Fourth Quarter 2010

Bonds: Conclusion

44

On the liquidity side, banks and public demand should be more than sufficient to absorb public issuance, for now. Refinancing needs at the high yield corporate, banks and emerging markets side are likely to pose a much greater risk in the future but companies/countries have/are profiting from the current investors thirst for yields to refinance and lengthen the duration of their repayment schedule. While many emerging markets are i much b tt shape th 10 15 years ago, th still remain d i k t in h better h than 10-15 they till i dependant on fl d t flows f from th US E the US, Europe and J d Japan. F th Furthermore never underestimate the power of crowd dynamic in this area of the market. Stress in Eastern Europe or inside the EU will have dramatic domino effects especially when, as we have documented in the past, more than 70% of the loans to emerging markets have been made by European financial institutions. This will provide a fantastic buying opportunities If you have to be long or if you can do relative value favor operating leveraged against opportunities. value, financially leveraged countries. Seasonality is still favorable for government bonds and negative for more risky bonds. The trend of the US Euro and UK government bonds markets is unequivocally down (for yields) Yields have pulled back to well defined US, yields). resistances where we would be buyer on weakness (yield weakness) or on further strength. We are seller of covered upside price volatility on excessive price strength. Corporate and emerging market bonds trends are rising. We prefer to be on the sideline. Remember that it is sometimes better to be out of the market wishing to be in than in the market wishing to be out out. Sometimes less yield is better.

Clue6

Fourth Quarter 2010