In the UK, macroeconomic conditions are currently very favourable for bonds, and in particular corpo...
In the UK, macroeconomic conditions are currently very favourable for bonds, and in particular corporate bonds. Economic activity has been growing quite well, and has just registered an annual rate of slightly more than 3% for the second quarter of this year.
Unemployment has been forced downward by the good economic growth and has fallen to just over one million, and continues to fall. The economic growth and declining unemployment have not triggered a wage-price spiral, which, in previous economic cycles, had led to rising inflation and interest rates.
Inflation is well contained, as the Bank of England's Monetary Policy Committee has been doing a good job in restraining annual price increases below the Government's 2.5% target. At the same time, the Government has prospered from the good economic growth, which has raised tax receipts and turned the budget deficit into a surplus.
The budget surplus was further boosted by the £22.5bn the Government received from the sale of third generation mobile phone licences.
The healthy state of the public finances has made the Government become a net redeemer of gilts.
However, the shortage of supply created by this net redemption, coupled with lower inflation expectations, has driven up the price of gilts and forced down its yields to a low level, in historic terms.
As a result, investors seeking a satisfactory income have been forced to look elsewhere. As the Government's surplus reduces its need to borrow from the bond market, it simultaneously liberates funds that can be made available to the corporate sector.
As a consequence, there has been a good flow of corporate borrowing in the corporate bond market.
More importantly, a large proportion of this borrowing has been of a very high quality, as firms with good credit rating have been borrowing more to finance their investment activity.
It is in this market that savers, looking for a haven for their funds, can find an alternative to gilts that offers an historically attractive yield, relative to gilts.
Investment-grade bonds provide a relatively stable income stream than non investment-grade bonds do. In the current environment of moderate economic growth, low and stable inflation, and healthy government finances, investment-grade bonds continue to offer an attractive yield, relative to gilts, without undue risk.
This favourable yield differential need not automatically imply superior returns because the shortage of the supply of gilts means that good capital gains are to be had from holding them. However, a superior income can be obtained from holding a diversified portfolio of investment-grade bonds.
With adequate diversification, such a portfolio further reduces the relatively small risk associated with these bonds.
Richard Woolnough is a fixed interest manager at Old Mutual Asset Managers
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