After a seemingly endless stream of gloomy news and falling values, sentiment has finally started to...
After a seemingly endless stream of gloomy news and falling values, sentiment has finally started to show signs of improvement in both equity and bond markets over the past couple of months.
Momentum continued to pick up throughout November and into December on the back of better than expected economic data.
A rise of around 6% in UK equity markets during November was good news for investment grade and high-yield corporate bonds, both of which outperformed gilts. The high-yield market was particularly buoyant, enjoying its best month this year as it climbed more than 4%. Nevertheless, it is still down around 13% for the year to date.
We have seen a tightening of investment grade spreads over gilts, although the index failed to reflect the full extent of the underlying volatility of many constituents. It seems investors that went out of their way to avoid volatile sectors of the market such as insurance, US autos and German banks in the third quarter are now enthusiastically embracing those very same bonds.
The positive market moves have been good news for bond investors but not for holders of gilts, who have seen the value of their investments fall. This has been the result of a combination of factors, including the general improvement in the economic outlook and renewed strength in equity markets.
Another contributor was Chancellor Gordon Brown, who announced the government had got its sums wrong and would need to borrow more than anticipated.
As investment grade bonds are priced over gilts, the sell-off in the gilt market outweighed the positive impact of corporate bond spread tightening.
We believe the position in the UK will be much more favourable than the global economy over the coming months, particularly continental Europe.
The market has serious concerns for the future of Ford Motors in the US. It looks as though the rating agencies might downgrade the bonds to high-yield.
This could lead to funding problems for Ford, which has around $160bn bonds outstanding, equal to about half of the total value of outstanding gilts. Quite simply, the high-yield market would not be able to digest a fallen angel of this size.
We are concerned the recent optimism over US economic data may be overdone, which would add to Ford's woes. However, despite our generally negative stance on overseas bonds, we will still buy them if they are cheap and have good prospects.
As well as concerns on the economic outlook for continental Europe, in particular Germany where unemployment is rising, we are conscious of potential problems if economic growth does not rebound in the US as fast as hoped. While the UK will not remain immune from external difficulties, our view is it will fare much better than other economies.
The generally downbeat view on the global economy is not supportive of credit markets and it looks as though the UK market will be the best performer over the coming months. The positive mood in the UK should ensure the recent rally continues.
Corporate bond markets have rallied.
UK corporate bonds should perform best.
The rally should continue into 2003.
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