The relative importance of government debt shifted decisively as of 13 June
The size of the sterling-denominated non-gilts market has overtaken the gilt market for the first time, according to Richard Woolnough of Old Mutual Asset Management, whose £23m Corporate Bond fund celebrates its one-year anniversary on 10 July.
That is a signal to intermediaries, many of whom are not fully conversant with non-government debt investing, that the relative importance of gilts versus non-gilts has decisively shifted, he said.
Using figures from Barclays Capital, the investment banking arm of Barclays Bank, Woolnough said the outstanding non-gilts market debt was £245.99bn, compared to £245.95bn for the gilts market. The decisive day gilts were outstripped as the larger asset class was 13 June.
That compares with the end of December 1990 when debt outstanding for the gilt market was worth four times that of the non-gilt market. Woolnough said: 'Both gilts and non-gilts are significant asset classes but now we have the minimum funding requirement review which has pointed towards the increased use of corporate bonds relative to gilts. That means, not only in terms of supply and market size are non-gilts more significant than gilts, there is also a shift among investors to focus on the asset class.'
Since the launch of the Corporate Bond portfolio, which aims to maximise total return through investment in primarily investment grade corporate debt as an alternative to gilt and high yield investment, the fund has achieved a total return of 8.67% to 19 June, according to Lipper.
That compares to the average total return in the UK corporate bond sector of 5.59%. With at least 80% of the portfolio invested in investment grade corporates, Woolnough said he is able to limit the risk of defaults that affect the higher yielding, non-investment grade sector of the market. The fund is currently 100% invested in investment grade corporates
Intermediaries chasing higher headline yields should note, Woolnough said, that the default rate for investment grade corporates is dramatically lower than for non-investment grade. That is why, he said, advisers selecting corporate bond funds should look at the underlying portfolios to ascertain the risks being taken to provide income.
The cumulative default rates over a five-year period are negligible for AAA, AA and A-graded bonds. For BBB-graded bonds, the lowest investment grade, that rises to almost 2%. For BB and B, non-investment grade paper, the risk leaps to around 10% and 22.5% respectively. For CCC-graded bonds the default rate tops 40%.
Currently, Woolnough is primarily invested in the five to 15-year area of the yield curve because Old Mutual believes interest rates are going to come down further. Traditionally, very long duration paper benefits the most from falling interest rates, although Woolnough said that if the UK joins the euro, UK rates, which are lower than euro interest rates, would have to rise.
Woolnough said: 'The market is still underpricing the probability of entering the single currency when looking on a risk/reward basis. Therefore, we are underweight the ultra-long sector.'
Woolnough has also altered his stance on telecom corporates, in which he had a zero weighting at launch. He said the supply and demand balance has largely been worked out and the more co-operative corporate climate in the sector has reduced default risk. Currently around 11% of the fund is invested in telecoms paper.
‘Most significant’ upgrade since launch
Changes happening over coming months
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Set for 1 April 2019