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Demand for bond funds has picked up in an improving but still challenging financial environment, offering portfolio managers an opportunity to differentiate themselves, adding value through credit selection, Moody's Investors Service said in a new Industry Outlook. However, uncertainties on the timing of future interest rate hikes will likely limit duration plays.
Since March 2009, the credit market has experienced strong performance gains as spreads on bonds have narrowed substantially. "Spreads are near historical levels; if further narrowing occurs, we do not expect it to happen uniformly. We also expect corporate debt issuance to slow down. In this context, credit selection will be the key to good performance," explained Marina Cremonese, author of the report. Meanwhile, bond funds' credit profiles are likely to stabilise based on an expected decline in defaults, a slowdown in rating transitions and a return to normal trading conditions.
As regards duration bets, Moody's anticipates that these will be limited during the first half of 2010, while the second half may offer greater opportunity for duration management as central banks start to unwind their expansionist monetary policies.
"Yield curves remain steep and uncertainties surrounding the recovery suggest that rises in interest rates will not happen until later in the year. Taking a negative duration stance too early could negatively affect bond fund performance — and therefore the trend in the first half is likely to remain duration neutral," Cremonese explained.
After peak outflows in the final quarter of 2008, the bond fund market started to gain momentum during the first half of 2009, and Moody's expects it to experience moderate inflows in 2010. As investor risk aversion has eased in recent months, the markets have again been supplied with liquidity and demand for bond funds has risen.
As a result, investors have been shifting money out of money market funds into bond funds. From January to September 2009, the bond fund sector has experienced EUR 190 bln inflows in the US and EUR 50 bln in Europe. Moody's anticipates that this trend will continue across most bond fund segments, but will be more pronounced with respect to short-duration bond funds, absolute return bond funds and exchange traded funds.
