Moody’s sees stable credit outlook for bond funds

Moody's Investors Service said that most of the credit conditions that supported the performance of the US and European bond fund markets in 2009 and 2010 are likely to continue. Consequently, Moody's said in an industry outlook that credit outlook is stable for the bond fund sector.
"Although we envisage a stabilisation in the credit quality of most bond funds, interest-rate rises could impair performance through present-value asset depreciation," explained Marina Cremonese, author of the report.
"Moody's expects inflationary pressures to remain subdued and interest rates to increase only gradually in the US and Europe during the course of 2011. As a result, the impact on bond fund asset prices will likely be modest and will vary depending on the strategy and duration of the funds; long-duration funds more likely to suffer than short-dated funds," added Cremonese.
The credit market has benefited considerably from the stimulatory monetary and fiscal policies in many countries, and both investment-grade and speculative-grade issuers have strengthened their balance sheets. In line with Moody's macroeconomic forecast for a sluggish economic rebound in 2011, the rating agency expects the credit quality of US and European issuers to continue to stabilise, a trend that was established throughout 2010. As such, default rates are expected to remain low.
However, although the credit outlook is stable, the Moody's report noted that as credit opportunities in the bond market become scarcer and bond-fund price volatility increases, equity and balanced funds could become more attractive to investors.
Fixed-income funds attracted massive inflows in 2010 for the second consecutive year, with inflows exceeding USD 440 bln. Since 2008, bond funds have experienced record inflows of more than USD 1 trln. However, although flows in fixed-income vehicles surpassed flows in equity funds, balanced funds and money market funds, they decelerated over 2010 and were 30% lower than the cumulative USD 622 bln inflows in 2009.
Overall, Moody's said that as developed economies continue their recovery and default risk continues to decline, corporate credit spreads could decline slightly, although this will occur at the issuer level, based on the quality and soundness of each issuer's fundamentals. Diversification and credit selection will become even more important within portfolios.