Over the past three months a major concern for investors in the US has been widening corporate bond ...
Over the past three months a major concern for investors in the US has been widening corporate bond yield spreads and a pick-up in default rates.
While the first is an indication of tightening liquidity conditions, the second is both part cause and consequence of those conditions, and a reflection too that global (and particularly US) economic growth is slowing. Both incite fears of a hard landing.
In this environment it would be natural to expect only the best quality government fixed income assets to perform well. Yet an examination of the UK bond markets during this period reveals a slightly different trend.
Ten year gilt yields have fallen 37 basis points (0.37%) since 1 September, but 10-year investment grade eurosterling bond yields have fallen an additional 27 basis points. Spreads have narrowed for AAA, AA, A and BBB rating classifications, according to indices maintained by UBS Warburg; only its speculative grade index shows a spread widening, largely due to the preponderance of telecommunication issues in the high yield market.
The best quality bonds have performed well, especially large, liquid sovereign and supranational issues, and some others have enjoyed less support.
Substantial new supply from previously high quality telecom issuers has pushed spreads wider and property sector bonds continue to trade at historically wide levels, due to worries about developments in one or two companies.
Within the industrial sector, the manufacturing and the healthcare sub-classes have also underperformed.
Spreads, however, have narrowed in most other sectors, financials, industrials from basic materials to transport, even media and advertising and, perhaps naturally as the economy slows, utilities.
Changes to the FT Gilt indices, a consensus that the UK Government's PSBR forecasts are too cautious and expectations that interest rates have peaked following the MPC members' unanimity at their last meeting that they should remain on hold have fuelled an impressive gilt market rally during the past month. Equity market risk premia has risen amid greater anxieties about corporate event risk.
Against this background, it is even more surprising that eurosterling bond spreads have narrowed. The reason is largely technical, and whether it will be sustainable for much longer could depend on confidence that corporate earnings will not deteriorate much further and that a recession next year can be averted.
Alternatively, the technical position could defy a worsening fundamental background. After all, credit spreads in the US and continental Europe have been and are on a widening trend.
Rupert Walker is associate director of Govett Investments
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