By Sajiv Vaid, bond fund manager at Royal London Asset Management Within the fixed income universe...
Within the fixed income universe during 2001, there has been one sector that has shone out and become firmly established as a market in its own right ' the non-gilt (credit) market.
Reasons for growth in the sector are well known, in particular the support derived from the fiscal and monetary discipline of the UK government since 1995. Over this period, government finances as a percentage of GDP went from a deficit of 5% to an estimated 1% surplus for 2001, which meant a marked decline in gilt issuance. The decline in government issuance coincided with more demand for fixed income assets by pension and insurance funds alike due to regulatory and asset allocation shifts.
The performance of credit markets to date disguises what has been a volatile year. While the market in aggregate has performed strongly, there are sectors and issuers that have witnessed extreme weakness. It could be argued that the tightening in swap spreads has been the primary driver of the credit market's performance relative to government securities.
Given the divergence in performance in 2001, investors are reminded against complacency as stock-specific risk has become a key theme throughout this year. More importantly, as the sterling market becomes deeper and more diverse, the likelihood is that migration and default risk will increase. This situation will lead to more divergence in performance among managers and the winners will be determined by those that have the more robust and disciplined credit process.
Another key event of 2001 was the growing importance of accountancy standard FRS17. The essence of FRS17 is for pension fund liabilities to be calculated using the yield from AA-rated corporate bonds and to value assets at market value. The net assets or liabilities of a scheme will be shown as a balance sheet item in the company accounts, from July 2003.
So far this year there have been two key announcements from leading UK Plcs. Earlier in the year, the £7bn ICI pension fund announced it had transferred £1.5bn from gilts into corporate bonds.
At the time, it was felt that this had created the pension fund industry's largest cashflow-matched portfolio. More recently, Boots stated it had sold all of its equities in its £2.3bn pension fund and replaced them with triple-A rated sterling bonds.
While FRS17 applies only to defined benefit (DB) schemes, its significance must not be underestimated, as DB schemes represent 80% of the £800bn of pension fund assets. Conservative estimates would indicate that about £60bn would flow into corporate bonds over the next few years so providing a positive backdrop for corporate bonds. It is likely that the ICI move will prove to be more representative and we see the Boots Plc announcement as the exception rather than the rule.
As the year draws to an end, we remain confident that next year should be another successful year for credit markets. While the structural demand will undoubtedly be a strong positive for credit other factors such as historically low interest rates and global recovery in the second half of 2002 should provide a more favourable backdrop for corporate earnings and bonds.
Fiscal and monetary support for credit.
Historically low interest rates.
Structural reasons for demand to continue.
An increase in default rate.
Stock-specific risk increasing.
Strong performance hides market volatility.
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