By Keith Kelsall is a fixed income strategist at BGI Government bonds like weak economies wherea...
By Keith Kelsall is a fixed income strategist at BGI
Government bonds like weak economies whereas corporate bonds like strong economies. Which are we going to get?
The UK has had a strong government bond market so far in 2002 after the cuts in the base rate to 4% at the end of last year and the relatively weak economic data this year. However, corporate bonds have not fared so well, with returns for the year to date slightly below those for government bonds.
There is no doubt the UK economy is experiencing some difficulty, although, if data collection is confined to hous- ing, you could be excused for thinking we are in a boom.
Economic growth for the first and second quarters of this year was 0.1% and 0.6% respectively, below what would be the long-term trend for the UK.
Manufacturing is having a horrible time, with negative growth since the middle of last year and the most recent data showing a contraction of more than 8% from one year ago. These are definitely numbers that must concern the Government and the Bank of England and are surely not conducive to raising the base rate.
Low inflation and the weak equity market are also factors that suggest the base rate should remain at 4%. This means government interest rates across the whole yield curve should not increase from their current levels.
In fact, short rates are starting to factor in the possibility of a rate cut, mirroring expectations both in the US and Europe that there could be interest rate cuts before the end of the year.
A growing problem in the UK is the buoyant housing market. This is unique to this country, due to the high home ownership and the near obsession with house prices.
Because interest rates are so low, people are eager to take on substantial home loans despite falls in their wealth caused by the declining equity market. The Bank of England would love to control house price inflation but, as mentioned above, with so many other indicators being weak, a rise in interest rates would be extremely difficult.
UK bonds should be, and are, benefiting from the extreme weakness in the equity market this year, as investors look for lower-risk assets. The concern over house price inflation doesn't yet seem to have filtered into the bond market. However, corporate bonds are suffering for some of the same reasons as equity markets: concerns over company accounting and a general weakening in corporate profits.
Despite recent weakness, UK corporate bonds have outperformed equities over the past 10 years, with a much lower risk. Corporate bonds are now paying too high a spread over government bonds, considering their risks, but investor sentiment is such that they are demanding a much higher premium on any riskier assets. This is unsustainable as investors continue to structurally shift into corporate bonds from equities in search of lower-risk assets with comparable returns.
Although it has been a bumpy ride for investors in corporate bonds recently, we would hold on as the spreads available are generous and, when comparing equities to corporate bonds, many investors will remember the pain of recent equity movements for some time.
Strong UK government bond market.
Interest rates are currently low.
Spreads in corporates are generous.
Corporates underperform government papers.
Economic growth is slower.
Weakening yen erodes foredin capital.
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