AS 2013 draws near, we should take a look at the important lessons we learnt and opportunities we enjoyed in 2012.

Asset class of the year: Bonds. Without a doubt bonds were the winning asset class of 2012. This was particularly true for investment grade rated bonds, regardless of duration. With interest rates across the globe at historical lows, the expansionary monetary policy pursued by the US Federal Reserve and the European Central Bank combined with fairly high levels of fear and volatility pervading the market, as investors fled to bonds as a safe haven. It’s useful to bear in mind that bonds are great tools to minimise downside risk since the issuers essentially pledge to repurchase the bond from you at a pre-established rate. Even when interest rates start to rise and bond prices decline, interest income will provide a given rate of return of the investor.

Sector of the year: While large financial institutions across the globe still struggle to shore up their capital and return to profitability, their bonds have provided investors with notably positive returns. Early bondholders of some issues from Bank of America, Royal Bank of Scotland, and Barclays enjoyed double digit holding period returns between March and December 2012. The prices of some of these bonds have risen as much as 22% in 2012. The financial sector has outperformed the market and similarly rated credits in other industries. The major challenges faced by large banks now include preparing for Basel 3, improving the quality of their asset and capital base, and sustainably generating profits. Based on the performance of these bonds, investors seem to believe that they are capable of handling these issues.

While there was a general improvement in the financial position of these large banks, bondholders benefited tremendously from the quantitative easing programs employed by the Federal Reserve, fearful market sentiment and lower volumes of new bond issuance. This rising demand for bonds and the reduced supply significantly contributed to the rise in bond prices that took place in 2012.

Bond structure of the year: Bonds at all rungs of the capital structure did well in 2012 with plain vanilla bonds leading the pack. Between 2009 and 2012 many financial institutions issued a variety of hybrid instruments (generally categorized as “fixed income”) which combined features of both debt and equity. Hybrids vary in structure but usually have long dated maturities (e.g. 2049) as well as terms and conditions that can lead to the suspension of interest payments or accrual, and even principal re-payment in some circumstances. Hybrids usually form part of a bank’s capital base and were primarily used to bolster the capital base of the issuer. Hybrids generally had higher coupons (between 6% to 13%) to compensate investors for these added risks. The prices of these instruments also shot up, despite the different risks. The hybrids were a good tool for achieving higher yields on investment grade credits. In the fourth quarter of the 2012 calendar year, financial institutions such as Barclays, Rabobank and UBS issued a new type of hybrid dubbed “coco’s” — contingent capital convertibles. These instruments emerged with even harsher terms and conditions. They can be converted into equity at certain times by the issuer, or could even be cancelled entirely, at which point an investor could lose his/her entire principal. Despite the higher risks inherent in this structure, they quickly traded up 5 or 10 points within the first few weeks of issuance.

We move into 2013 with very low bond yields. The fate of the US economy and the Euro zone is still uncertain but will continue to send ripples through the markets for the next few years. Prices in emerging markets are finally softening and could present opportunities for investors. Stay tuned to The Sterling Report to find out how you can maximise on the new opportunities 2013 has to offer.

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at https://www.sterling.com.jm

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