Will 2014 be the year of the bond?

A variety of factors mean the year ahead should be better for investors than the last.

Janet Yellen replaced Ben Bernanke as US Federal Reserve Board chairwoman. Charles Dharapak / AP Photo

As Mena bond investors, we are confident 2014 will be a better year than the one we just bid farewell to. We anticipate the volatility affecting bonds to dampen drastically this year and to provide us attractive risk-adjusted returns. We expect with confidence that investors with flexible investment guidelines should be able to strike mid-single digit returns with relatively low volatility.

Why do we think so? Well, let’s take it apart to understand the dynamics involved.

At the beginning of the year, fixed income was one of the hottest asset classes. As fund managers, we were running a race against time to earn for our investors better returns. In the absence of liquidity, every bond we touched gained higher levels as almost nobody wanted to sell. New bond offerings were oversubscribed by eight to 12 times.

Sizes of intraday deals doubled with reverse inquiries and maturities pushed beyond 2043. Subordinated equity-like bonds had become a favourite destination for yield-hungry investors who were sometimes also using debt to substantiate their positions and returns.

However, we eventually turned cautious as 10-year US Treasuries hit all-time low levels, sinking to between 1.50 per cent and 1.85 per cent, compared with the 5 per cent levels reached before the global crisis. Fuelled by signs of recovery in the US economy and the Fed’s alarm about a heated bond market, we employed tactics to hedge against interest rate sensitivity and put more emphasise on lower duration bonds.

The Fed’s announcement in May significantly tampered with the bond market, and the correction drove many to reduce excessive leverage in their investments and was a win against the development of potential bubbles. Furthermore, volatility started to reduce. The market is now familiar with the idea of tapering, and we have seen a mild reaction to the recent reduction of US$10 billion worth of monthly bond purchases.

The market now is aware that the Fed only plans to reduce the purchase of bonds and will not stop completely.

We anticipate tapering to occur throughout the year and beyond as the Fed will be purely watching macro data under the leadership of the more dovish Janet Yellen. We do not expect the first actual increase in short-term interest rates until 2016. With an inflation expectation of 1.5 per cent for 2014, the Fed feels no inflationary pressure.

What is more, should the Fed rush preemptively and US yields pick up faster, we could see hazards on growth and fragile mortgage market, which is totally unacceptable by policymakers. While we are hedged, we would not expect 10-year US Treasuries go to beyond 3.5 per cent this year.

A benign regional outlook also contributes to a positive outlook this year. Ample liquidity lends important technical support to the asset performance, while oil-rich governments and corporate sectors are benefiting from rising cash flows. The UAE property market is improving on the back of the growing economy and excitement from Dubai Expo 2020.

In the banking system, the asset quality will improve further as provisioning declines. Both Qatar and Saudi Arabia continue to thrive on healthy energy prices.

Finally, we are not believers of the so called “Great Rotation”, in which investors sell bonds to rotate into equities. Given global demographic trends, the majority of assets belong to investors who are either about to enter into retirement or institutional investors that must invest in bonds to match their liabilities. What is more, a recovery phase lasts four to six years within a cycle and we are already through four years of recovery. Coupled with current yield levels, we are confident that 2014 will provide us a better year than 2013 did.

Ali Soner Guney is fixed-income fund manager for NBAD Asset Management Group