This is turning out to be another difficult year for bond investors. In the government markets, we h...
This is turning out to be another difficult year for bond investors. In the government markets, we have been faced with inverted yield curves, tough competition from rising interest rates on cash, and a miserable trickle of new stock supply. There has been nothing to arouse the interest, let alone the excitement, of individual investors or asset allocators. It would appear the sooner the year is over and the underperformance relative to cash slips away into the historic record, the better for all concerned.
On the corporate credit side, circumstances have likewise been less than supportive. Shareholders are generally happy to see increased gearing on company accounts, making up for the shortage of government supply with a heavy flow, sometimes amounting to a flood, of new issues.
In the market background, economic and financial events have also proved almost entirely negative. The financing for third generation (3G) mobile telecommunications, the cost of replacing obsolete technologies, the oil price increase and even the widespread political protests, all have negative connotations for corporate cash flows and creditworthiness.
In the UK, even the expected salvation of the market, the actuaries' recommendation to reform Minimum Funding Requirement, a test on a pension fund to check it's ability to provide for its members, by increasing their exposure to corporate bonds, has turned out to be a damp squib.
The report was viewed as more of a discussion document with the Myner's report, expected in the autumn, becoming more significant. Current expectations are that the Myner's report will be more far-reaching by encouraging increased investment in venture capital.
Overall it appears that any changes in pension fund regulations could be years rather than months from occurring.
And yet, despite the unrelieved gloom, there have been pockets of good performance. The high yield indices have outperformed their investment grade counterparts.
In the financial sector, subordinated debt is starting to perform better and recent telecoms issues, correctly priced, have delivered respectable returns.
After two years of bad news and poor performance, might bond investors' patience be about to pay off? Specifically, are there discernible changes in the market background, which point to a genuine improvement in prospective returns?
Firstly, we need to look at valuations. Government bonds are clearly not cheap, but the same does not hold for corporates. The general market in corporate bonds was re-priced by the BT credit rating downgrade.
This was widely expected but the possibility of the rating going to BBB was not. This highlighted the additional costs that BT and other telecom companies would incur in funding the 3G licenses.
However post the sell off corporate bonds are now exceptional value to investors. Telecom companies may not be the ideal area to invest but property companies are offering 10 and 20 year bonds with yields of 7-7.5%. In the banking sector Tier 1, highly subordinated debt, issued by some of the high street banks has yields of 7.5% and slightly higher.
Mobile phone licences
Secondly, the economic background remains disinflationary. Generally this would be positive for bonds however much of the good news is priced in. So when events such as a jump in the oil price and unexpected higher costs of mobile phone licences occur they can act as a short-term shock to bond yields.
The major concern is that the inflation genie has escaped out of the bottle. These shocks tend to be short term by nature and bonds will recover especially with the world's central banks targeting low inflation. Oddly it is the world economy not growing fast enough to re-establish pricing power for distributors or suppliers that should concern corporate borrowers.
The ability to service a fixed coupon becomes increasingly difficult with no pricing power. The deflationary environment does mean that the corporate bonds need to be carefully selected. Pricing power is a key factor. This would generally put bonds issued by industrial names such as Corus out-of-favour and possibly certain retailers where margins continue to be squeezed. Pharmaceutical companies and to some extent oil companies would be better investments as they are less constrained.
Thirdly, the balance of supply and demand for bonds, while arguably unsupportive, is at least fully discounted at current yield spreads. In the UK and US, we are arguably very close to the top of the interest rate cycle.
Disinverting yield curves improve the attractions of bonds relative to cash. The supply of new corporate stock is heavily discounted in the market, and it is difficult to see how this factor can produce any further re-pricing shocks.
The Telecom issuance previously discussed in this article has been heavily signposted to the market so any reduction in the amount of debt to be issued, asset disposals or even the raising of more share capital by Telecom companies will act as a positive driver to the corporate bond market.
Supply could further dry up if the Euro market focus more attractive for issuers. Many issuers have chosen the euro market in preference to sterling, as the deal sizes have been larger and the restrictions on the borrower less. At this juncture, it might only take small shifts on the demand side of the equation to move markets a long way. On the institutional side they is the continual talk of changing benchmarks.
The decline in Gilt issuance results in many investors buying already overvalued government debt, as it is 'part of the index'. This in turn makes the bonds more and more expensive.
Falling cash rates
Paul Bruns and Elaine Parkes
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