Fund manager's comment/Anna Lees-Jones
Second quarter consolidation in bond markets has pushed yields to levels that should appeal to income-conscious and defensive investors. The yield on the 10-year benchmark UK gilt has risen from 4.5% to 5.3% since the end of March. Investment grade corporate bonds still yield more than their gilt equivalents, but, thanks to the continuing narrowing of spreads, their performance has been more resilient.
As a rule, we believe the sensitivity of a portfolio of investment grade corporate bonds is around 80% to inflation/interest rate expectations and 20% to the fortunes of the companies issuing these bonds. Recent caution has been triggered by a rise in inflation, albeit only from 2% to 2.4%, and by Bank of England concerns over the implications of a rampant housing market and buoyant consumer spending.
However, some of the inflationary drivers, notably oil prices, may moderate in the near term, enabling the bank to justify holding interest rates. Nevertheless, while we believe the market may be too pessimistic in expecting a rise in interest rates within three months, 5.25% still looks likely to be the bottom of the current cycle.
Corporate bond yields over gilts vary from 0.5% over their gilt equivalents for AAA-rated bonds to approximately 1.7% for BBB-rated bonds, the lowest credit tier within investment grade. These spreads have already narrowed considerably over the past 12 months. Following the agreed abolition of the Minimum Funding Requirement, many UK pension funds have shown a greater readiness to diversify their sterling bond portfolios by reducing gilt weightings and switching into suitable corporate bonds.
Hitherto, conservative pension funds have confined themselves to AAA securities, but there are signs of increasing willingness to buy A or even BBB-rated issues, where yields over gilts are much higher. With current yields on medium-dated bonds in these categories ranging between 6.3% and 8.4%, they offer attractive yields coupled with the prospect of future capital gains, if our view on narrowing spreads proves accurate.
Some investors might prefer gilts as the ultimate safe haven. Gilts are not risk-free in the face of recession, but the Government still commands greater financial resources than even the strongest AAA issuer.
The outlook for UK interest rates will clearly play an important role in the conduct of income seeking retail savers. The yields offered by funds focusing on investment grade corporate bonds are close to 6%, which is currently above those offered by all but the most generous deposit accounts.
In the light of forecasts of a stable UK interest rate environment, we believe the case for retail savers to continue diversifying away from cash remains compelling.
Bond yields standing at attractive levels.
Spreads on corporate bonds narrowing.
Move into bonds has further to run.
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