UK and European government bonds are at the lower end of good value but investors fleeing from volat...
UK and European government bonds are at the lower end of good value but investors fleeing from volatile equity markets continue to support prices.
Kevin Adams, director UK fixed income at Credit Suisse Asset Management, says: 'Bond yields have been in a range of between 4.5% and 5.5% for the past three years but we are very much at the lower end of that range now.'
Prices have risen as yields have fallen over the past three months because interest expectations have changed in the UK and elsewhere and 10-year UK bonds are currently yielding 4.6%, down from about 5.3%-5.4% in April/May, .
Adams says it is hard to tell whether the flight to bonds is due to lack of confidence in equities generally or uncertainty over what is going to happen to interest rates.
He says: 'At the start of the year, expectations were that interest rates would rise over the course of 2002. If you looked at what expectations were priced into the futures markets six to eight weeks ago, it was that rates would go up in the UK towards 5% by the end of the year. All of that has been completely wiped out of the market and bond markets have rallied because of that.'
It is this uncertainty of economic outlook and volatility in the equity market that will keep government bonds relatively well supported despite the argument that, on an historic basis, they are looking expensive.
David Cryer, director of Treasuries and derivatives at Insight Investment, says: 'On a valuation basis, we are still struggling to say bonds offer good value.
'Lending money for 30 years at 5% does not seem a great yield. The fundamental basis is that markets are overvalued in the UK, Europe and the US.'
Equity markets have reacted on the possibility of a rate cut and, if that does not happen, especially in the US, and there is a dramatic sell off, there could be a rally in gilts and European bonds, says Cryer.
'But that presupposes there has to be a cut in interest rates to support the equity market,' he adds. 'Confidence seems so fragile but that's where we are looking for guidance.'
The problem may be whether there is enough capacity in the bond market. Until a year ago, this could have been more of a concern in that governments were mostly in budget surplus and did not need to borrow from the market. However, both the UK and US governments have moved back into budget deficit, according to Adams.
'So, in some ways, there is an increased supply of government bonds to meet that demand,' he says. 'But the increased demand of investors coming out of equities has been sufficient to overwhelm the increase in supply and prices have risen quite substantially and fiercely over the past month or two.'
The question is where the bond investors are coming from and if there are other factors at play beyond reactions to the equity market.
'The obvious reverse trade out of equities was probably led by pension funds and insurance companies as very much a defensive play,' says Cryer. 'What we are puzzling over is if there are other investors pushing that trend in price rises. We are getting to historically low yields both in the US and the UK, which suggests there is speculative money in there.'
Bonds are a safe haven.
Still uncertainties over equities.
Increased interest rates turn market.
Bonds are starting to look expensive.
Demand may outstrip supply.
Hedge funds may be driving prices.
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