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Bond bubble fears are all hot air, says Standish’s David Leduc

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David Leduc, managing director of global fixed income at Standish and manager of the BNY Mellon Global Strategic Bond Fund, says global markets have provided some inclement conditions in which to work.

2010 year-to-date has been a challenging investment environment, characterised by many conflicting signals as to whether the global economic recovery has begun to take root or not.
 
Leduc and his team believe that the enormous volumes of stimulus provided by the authorities in 2009 helped lead to signs of a recovery in 2009 and early 2010, causing riskier assets to rally sharply. However, this was interrupted sharply when the European sovereign debt crisis started to hit in March 2010. 
 
Meanwhile, recent press coverage has led to discussion about the emergence of a “bond bubble”, but Leduc is quick to point out what he considers to be the flaws in this argument.

“We don’t deny that certain areas of the market may be a little overvalued at the moment,” he says, “but we nevertheless maintain that inflationary pressures in Europe and the US are likely to abate, especially given the backdrop of high unemployment and low growth. 
 
“When these considerations are taken into account, we believe that bonds start to look much less overvalued. All in all, therefore, we would argue that talk of a bond bubble is something of a nonsense when you consider their intrinsic value. That said, our tendency at the moment is to be relatively cautious; we don’t want to expose investors in the fund to undue credit risks,” he explains.
 
Responding to the renewed risk aversion in the markets, Leduc explains that the most significant change to the BNY Mellon Global Strategic Bond Fund’s portfolio in recent months has been visible at the sector allocation level.

“At the end of 2009 we had overweight exposures to high yield credit and emerging market debt,” he says. “As market volatility increased, we began to reduce our risk exposures, such that by the end of the second quarter of 2010 we had a roughly neutral exposure to corporate bonds.” 
 
Meanwhile, the fund’s emerging markets debt exposure has been reduced, and as elsewhere, holdings in this area reflect the team’s broad preference for higher quality sovereign issues; the fund therefore maintains exposure to Brazilian bonds, while an earlier position in Hungarian government debt was cut before yields subsequently spiked.
 
Furthermore, consistent with the team’s decision to reduce the overall level of risk in the fund, within the credit portion, exposure is pretty well diversified between issuers and sectors. Specifically, the fund does not own any Tier-1 bank bonds, as previous holdings were sold as part of the risk reduction effort.

“Our preferred credit holdings within the financial sector include issues by BNP Paribas, Societe Generale, Citigroup, Barclays and JP Morgan – so, predominantly well-capitalised, global banks,” says Leduc. 

Meanwhile, Leduc highlights the fund’s underweight exposure to peripheral European sovereign bonds as a particular area of strength.

“Our low exposure to peripheral sovereign bond markets was a significant boon for relative performance in the period following the Greek debt crisis.”

The fund’s allocations in this area have been fairly flexible, and overweight positions in Spanish and Italian government bonds (subsequently reduced and sold, respectively) during the risk rally in July 2010 were in fact strongly beneficial to returns. 
 
Leduc has also studiously avoided Portuguese and Irish debt, as he considers these to be “smaller economies with big problems”. Conversely, he is quick to emphasise that he does not have significant concerns about the sovereign creditworthiness of Spain or Italy, arguing that these bonds offer an attractive opportunity to pick up extra yield over German Bunds.

“We believe these spreads are probably higher than they really should be; ultimately, this will depend on individuals’ assessments of the credit risks posed by these bonds,” he says.

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