For holders of gilts, there are currently two very attractive alternatives in UK bond markets. The ...
For holders of gilts, there are currently two very attractive alternatives in UK bond markets.
The (very risky) small but developing sterling High Yield market covers many companies in the early stages of development. With an appropriate level of dedicated credit resource they provide significant upgrade opportunities, as well as high income.
I exclude from approval in this category all preference shares. With fading hopes of buy-backs from the major financial issuers and no trading liquidity as market makers have disappeared, prospects remain bleak.
The (very safe) less well-known alternative is the class of bonds issued by entities rated AAA. In terms of credit risk these bonds are not on the same planet as High Yield.
One is the European Investment Bank (EIB), financing infrastructural projects across the EC, the shareholders of which are the governments of the EC. It is like a government guarantee from each and every EC country. EIB bonds yield between 1 to 1.25% above gilts of a similar maturity.
The EIB raises capital from the bond markets to on-lend and it can obtain better borrowing rates in the capital markets by using the interest rate swap market. It issues fixed interest debt and swaps the fixed interest to floating rate, so that instead of paying a fixed coupon every year, it pays an amount which changes with Inter Bank Rates.
The net effect of this procedure is the yield difference between fixed interest gilts and EIB bonds is highly dependent on the level of swap spreads. Swap spreads are the premiums investors are prepared to pay to swap floating for fixed. If interest rates are expected to rise, they will go up and vice versa.
Swap spreads are very high at the moment, which means EIB bonds have underperformed gilts. While EIB is still issuing bonds, wider swap spreads mean higher EIB yields relative to gilts. This is why you can get an extra 1 to 1.25% above gilts.
Shorter term, swap spreads may experience some volatility as UK corporates continue to fund overseas and use the swaps market to swap the liability into sterling. However, AAA issuers will absorb the swaps by issuing more bonds to domestic investors.
Longer term, two factors of huge influence are swinging round in favour of lower swap spreads: gilt issuance and interest rate expectations.
Lower gilt issuance is correlated with higher swap spreads. The Government is going to spend more ahead of the next election and that will be financed by more sales of gilts. In addition a slower economy will generate lower tax revenues and increase the need for more debt so that the government can maintain its spending programme.
Andrew Sutherland is investment director at Standard Life Investments
Clarke replacing Balkham
'Deep-dive analysis of client behaviour'
Ways to mitigate April’s increases
The best equity income funds examined