While the current backdrop appears supportive with regard to bonds, investors need to be aware that the credit market is far from risk free
With the New Year well and truly upon us, many investors could be forgiven for thinking that it is merely proving to be a continuation of 2002, with equity markets struggling in what many now believe to be a permanent environment of low inflation and low investment returns.
As this continues, more people start to consider investing in bonds as alternative investments to equities. Some even go as far as to state this to be an ideal time to be buying fixed interest given the persistence of equity markets' weakness.
But is this really the time to consider switching into an asset type that has enjoyed a bull run lasting over a decade? As always, that question should be turned back to the investor. Are they happy with the prospect of a mere 5% to 6% annual return, most of which is from income? If so, then the sterling corporate bond market clearly remains attractive.
But potential investors need to be advised that this market is far from risk-free. The higher yields are there for a reason and sterling bond markets face many challenges in the year ahead, both in terms of economic and market developments.
From an economic point of view, the current backdrop still appears to support bonds. Inflation remains low, monetary policy remains accommodative and the major industrialised economies continue to disappoint.
Added to these there is the continuing political uncertainty in the Middle East, with the likelihood of war still troubling investors' minds. However, all these facts are nothing new and bond prices already discount much of them. Also, this is an environment that primarily favours government bonds rather than their corporate cousins. In the UK, there has recently been much comment about corporate debt appearing attractive following the recent widening in spreads over gilts.
But such a widening took place for a reason, namely a severe deterioration in the prospects for the corporate sector. It is ironically the very same deflationary forces which make bonds appear attractive that are also imposing so much pain on companies.
Should the prospects for UK firms start to improve, this will most likely be in a rising growth environment, one that will probably see rising yields.
Thus, the most probable scenario in which corporate bonds start to outperform gilts substantially is likely to be one in which bond prices are actually falling, a market from which investors would rather steer clear. This is currently the conundrum potential bond investors have to face.
Several bullish commentators also believe that bond markets will benefit from equity market weakness, pointing to their reciprocal performance in recent years. However, like equities, fixed interest markets enjoyed the continual fall in inflation and interest rates throughout the second half of the 90s.
Those who believe that that bond and equity prices normally move in opposite directions need only look at this period to see how mistaken they are. The current phenomenon of equity and bond markets moving in opposite directions is merely temporary. Unlike equity markets, the bond market's bull rally has carried on into the 21st century, helped in the UK by pension fund legislation in the form of the Minimum Funding Requirement and its younger brother, the FRS 17 Accounting Standard.
These both had the effect of increasing institutions' demand for bonds, an asset type that they had largely run down during the heady days of double-figure annual returns from equities. In addition, there has also been large scale buying by UK insurance companies for solvency purposes.
However, such buying has not been indiscriminate and the mere fact the market has absorbed this much demand without lurching sharply upwards highlights the fact that there is healthy two-way business in this market and this should send a signal to investors about future price actions.
There is another challenge facing corporate bond investors in the UK in the months ahead, however, and that is how it can improve its current poor level of liquidity. At the end of 2001, many observers highlighted the fact a landmark had been reached in the sterling debt market. The total value of non-government bonds in issue was now larger than that of the gilt market.
Surely this was a sign that the market had come of age and that it was now set to eclipse the UK government market in terms of activity and importance, wasn't it? Well, sadly, this appears to be merely a case of zealous sales forces attempting to drum up interest in a market that was looking tired after a decade-long bull market. The total size of outstanding issues in these two sectors is, quite frankly, a meaningless statistic.
It totally fails to take into account the important factors, such as the nature of the issuer (World Bank or WorldCom?), the nature of the various types of stock (high yield, asset-backed, debentures) and, most crucially, the liquidity of the two markets.
Corporate debt is nowhere near as tradable as gilts, which have a large number of marketmakers, inter-dealer brokers and a liquid futures contract that enables traders to hedge their positions.
This relative illiquidity of the market is highlighted by the fact that the national newspapers have never published a comprehensive list of prices of the large corporate bond issues that may be of interest to investors.
Also, one would have thought that a market that was well developed would by now have a benchmark index that was industry standard in order for investors to measure both returns and fund performance.
Until last year, the market had to rely on brokers' own indices, of which there were many different ones on offer, and to a great extent still does. However, progress is being made with the introduction of the iBOXX series of real time sterling bond indices, which can only help improve the visibility of performance data for such an important market. It will be interesting to follow how this establishes itself within the fund management industry in the months ahead.
This is now a crucial moment in time for the sterling debt market. The bull run that has lasted for more than a decade (some would argue decades) appears to have run its course. 2002 was an extremely bond-friendly year, with interest rate reductions in the US and Europe, severe equity market weakness and geopolitical uncertainty.
Yet sterling bond investors saw little, if any, return in excess of their dividend income. Having underperformed gilts throughout last year, corporate bonds may now offer value in relative terms, but total return investors cannot escape the conundrum that even when they start to outperform it will be in a rising yield environment (as corporate sentiment improves from the current depressed levels).
This, of course, means lower bond prices and negative returns. If, however, we truly are now in a low growth and low inflation, or even deflationary, environment then fixed interest markets look set to go from strength to strength, but with corporate bonds underperforming gilts still further.
For income seekers the current level of spreads over gilts does look attractive, but this is merely the reward for taking on added risk and lower liquidity.
From an economic point of view, the current backdrop still appears to support bonds.
2002 was an extremely bond-friendly year, with interest reductions and severe equity market weakness.
Despite this, sterling bond investors saw little, if any, return in excess of their dividend income.
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