With UK and world growth picking up bond investors are becoming fixated by interest rate rises and i...
With UK and world growth picking up bond investors are becoming fixated by interest rate rises and inflation and, subsequently, we have seen an acceleration in the rise.
This negative scenario should continue in the short term as UK economic growth moves above its trend rate and labour markets tighten further. The global bond markets currently seem to fear inflation in a way that the equity markets do not. We tend to side with the equity market anticipating rates to peak during the course of the year and inflation will remain comparatively low.
One of the most striking aspects of markets last year was the divergence between high yield and high grade credits. High yield credits provided a positive total return as the high coupon and improved sentiment towards the telecoms, media and internet sectors boosted the asset prices that support bond values. They also benefited from event risk as these higher valuations were unlocked by IPOs or take-overs as incumbent companies and late-comers sought to buy into this developed market.
Investment grade markets in contrast, without the benefit of improving spreads and being exposed to less attractive sectors, suffered as fears of deregulation in utilities and margin erosion in banking took hold. We expect high yield bonds to continue to outperform in 2000, as they benefit from higher levels of underlying company growth. In particular, cyclical sectors should benefit as both capacity utilisation and price rises lead to improved profitability.
Also, the industries are themselves being restructured as consolidation occurs. Investors hope that more rational product pricing and investment strategies will emerge as companies consolidate and take larger market share, rather than simply maximising their own short term profitability through capacity expansion.
The cyclical sectors of chemicals, paper and packaging should outperform the market as these companies benefit from higher world growth and rationalisation of the cost base.
We continue to like telecoms, especially the alternative carriers such as Colt and Energis. We think the regional providers like Jazztel, Tele1 and Versatel are especially interesting. These companies are targeting the under-served small and medium-sized business market who currently have little choice of providers.
The niche nature of the market and limited competition ought to allow good returns to be earned from a very rapidly growing market as more services are demanded and penetration rates rise. The consequence of this should be improvements in the credit ratings for these companies, or takeover.
Overall, the market outlook looks testing as interest rates rise with few signs of a US slowdown - yet. We do expect UK rates to peak below 7%, implying further risks in government bond prices. It is for this reason we prefer corporate bonds this year.
Chris Murphy is fund manager at Framlington
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