Between the start of the year and 5 August the return from the gilt market as a whole was negative b...
Between the start of the year and 5 August the return from the gilt market as a whole was negative by just under 2.5%. To some extent this disappointing performance was due to investors factoring in the possibility of higher interest rates later this year. This seems logical, and as the consequent implications for corporate borrowers would be unwelcome, it might have been reasonable to expect even worse returns from non-government issues, the degree of underperformance inverting with the level of rating.
In reality, according to the SBC Warburg indices, every broad category from triple-A to speculative grade has produced a better return, and the lower the rating the better the outcome. Within the different maturity ranges there have been significant variations. The worst gilt performance came from the five- to 15-year maturities, which showed a fall of 4.7%. While in non-governments the wooden spoon went to the triple-A sector over 10 years, which fell by 4.4%. Speculative issues gave positive returns throughout the range, although they lagged triple-B over 10 years and beyond.
Liquidity and technical influences are the usual suspects. No matter the macro outlook, if supply and demand are out of kilter the market, is liable to adjust through the price mechanism towards a state of equilibrium. In the opening quarter of this year, liquidity flows from fixed-income Pep purchases were an enormous catalyst for corporates, and although Isa sales have been rather muted, they can still be meaningful. The main technical driver has been the interest-rate swap market, where the activities of an array of participants have impacted on credit spreads. This has been especially noticeable in, and contributed to the relatively poor performance from, the triple-A sector.
There is little prospect of the swap market closing. Nor should it, as it provides a valuable service to the banking community, portfolio managers and corporate borrowers alike. What may be at risk is the level of liquidity in this market, as there could be a withdrawal of capital if rumours of major losses by some proprietary desks prove correct. Certainly, it would be surprising if the volatility in the last few months has not caused problems somewhere in the system.
Although 20-year gilts yield less than base rate, interim maturities are higher. Against cash deposit rates, the pick-ups are of course greater, and the widest differential is around the six- to seven-year area, where many portfolios have large weightings. It will probably require interest rates to be hiked by a minimum of 2%, and deposit-taking institutions to maintain their margins, before the running yields in the cash market significantly exceed those from corporate bonds. Liquidity flows should not evaporate, but may diminish temporarily. It seems that economic fundamentals will continue to battle with these other influences for primacy in the setting of long-term yields.
Ian Dickson is divisional director corporate bonds at Henderson Investors.
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