By Paul Grainger is senior investment manager at Gartmore In recent months, a number of high-pro...
By Paul Grainger is senior investment manager at Gartmore
In recent months, a number of high-profile corporate casualties, combined with an uncertain economic background and rising tensions in the Persian Gulf, have weighed heavily on corporate bond markets as investors have shown a diminished appetite for credit risk.
Against this background, it is easy to overlook the fact that a number of companies have already taken the opportunity to reduce gearing levels and restructure their balance sheets through embarking on debt reduction programmes, while cutting expenses and strengthening cashflow.
Indeed, despite tight credit conditions a number of companies with sound business plans and predictable cashflows have been able to weather the storm and successfully access capital markets through bond issuance.
While the recent economic data releases from the US, such as manufacturing and consumer confidence numbers, have indicated a softening of activity, this should be seen in the context of an abnormally strong rebound during the first quarter.
On this latter point, recent economic data has raised concerns that the recovery is faltering. Continental Europe in particular, is showing significant risk of a double-dip or at best a prolonged period of sub-trend growth.
However, we believe the outlook for the UK economy is brighter, with growth underpinned by substantial increases in government expenditure, a strong consumer sector and historically low interest rates. Looking ahead, the backdrop of a gradual, albeit moderate, global economic recovery, combined with subdued inflationary pressures, indicates interest rates should remain at relatively low levels and be supportive for corporate bond markets.
Aside from cyclical factors, from a longer-term perspective a number of structural issues, most notably the changing regulatory landscape for UK pension funds are likely to trigger greater demand for sterling-denominated investment-grade corporate bonds.
In the near-term however, equity market volatility is likely to persist until clearer evidence of a sustained improvement in the macroeconomic background emerges. Investors are likely to remain risk-averse in this climate and shy away from some of the weaker investment-grade bond issues on BBB ratings.
Furthermore, the risk of further poor corporate newsflow remains. The latest default report from US ratings agency Moody's showed that the credit cycle, defined as ratings upgrades less downgrades divided by the number of rated issuers, deteriorated in July in the wake of WorldCom's demise.
The forthcoming third quarter reporting season will provide a key barometer on the health of the corporate sector and investors are likely to remain focused on credit quality, avoiding issues where there are significant refinancing concerns and opting instead for cash generative businesses with strong franchises and sound management.
In this environment, we favour a relatively defensive approach to sector allocation, focusing on non-cyclical consumer issuers, together with well-capitalised UK banks and selected telecoms.
Balance sheets repaired and debts reduced.
Modest growth, low inflation and low rates.
Institutional interest in corporate bonds.
Investors likely tp remain risk averse.
Risk of further negative corporate news flow.
Faltering economic recovery.
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