By James Foster, manager of the Isis Extra Income Bond Fund Although gilts and investment grade ...
By James Foster, manager of the Isis Extra Income Bond Fund
Although gilts and investment grade bonds have undoubtedly offered beleaguered investors the best of a bad lot over the past three years, it seems their run as the outstanding asset class may be coming to an end.
For all their ferocity, the events of 11 September were at least quantifiable ' the market could eventually draw a line under them. But when, post-Enron, it emerged that investors could no longer trust the numbers, they could not begin to quantify what the damage might be, it signaled another surge of funds into the relative safety of the gilt and investment grade sectors.
The problem following this latest credit migration is that gilt yields are now at their lowest for almost 40 years. The government's 7% 2002 issue that matured this summer, for example, released billions into a market now offering an average of only 4.5% in yield terms. This left many wondering how to make up a 3% shortfall in their investment earnings.
Whether interest rates plateau here or creep lower, we still see the gilt and investment grade sectors as being poised on the verge of a new investment cycle.
For one thing, government spending must rise in the short-term. There is always an election around the corner, but right now the UK is experiencing the kind of labour unrest not seen since the 1970s with deep divisions over everything from the ailing rail network to the examination blunders in the education system.
Alistair Darling may have signaled the way with his promise of £145m to relieve the agony of Britain's roads, but funding a mini-roundabout and a half mile of cycling lane is hardly going to put the country back on its feet. Serious money will need to be spent and this will go a long way to easing the current under-supply in the gilts market, so hence lifting current yields.
Investment grade bond issuers have had difficulties with which to contend but, encouragingly, they continue to be viewed on a stock specific basis. Historically, economic uncertainty, the spectre of another oil war or blue chips such as JP Morgan reporting a 91% fall in profits would all be enough to send investment sectors flying sideways.
We would expect to see the spreads between utilities, industrials and financials moving to painful extremes but this has simply failed to materialise.
The individual casualties such as British Energy, Bombardier or Texas Utilities have all been brutal in their way, but they have not sparked any mass sector exodus. For every JP Morgan, it seems there is a Barclays or a Citigroup that is still doing quite nicely thank you. Another good sign is new issuance, although slow, has also recommenced after a three-year draught on investment grade paper.
Another strong indication of the cycle's imminent progress has been the continued efforts by companies to restore their credit ratings.
This is something of which we can expect to see a lot more as the rigours of bondholder value continue to demand less gearing on company balance sheets. So long as this holds true, the prospect of stable capital values and moderate yields will be more than enough to catch the eye in the current environment.
Need for public sector spending to rise.
Companies now more credit ratings defensive.
Consumer demand for annuities rising.
Gilt yields currently stand at a 40-year low.
Demand will keep yields at moderate level.
Uncertainty and the threat of a third 'oil' war.
Reasons to be cheerful
Total investment reaches £9m
Medium to long-term capital growth