It has been difficult for bond funds of any kind to shine against the recent dull background. Equiti...
It has been difficult for bond funds of any kind to shine against the recent dull background. Equities have stolen all the performance prizes for the year to date, while concerns over the possibility of rising US interest rates have blighted sentiment towards government stocks and corporate bonds in all other major international markets, including the UK.
New investors in corporate bonds can be forgiven for wondering why the comparatively easy gains achieved in 1998 have not so far been repeated in 1999. Perhaps their time horizon was a little too short term.
There are some key factors to consider in evaluating the prospects of bonds. First, in our view, investment grade corporate bonds have sensitivity of around 80% to interest rates and 20% to equity factors (the ratio for high yield corporate bonds is closer to 50/50). Yields on gilts have risen significantly since the start of the year, for example the benchmark 10-year gilt now yields 5.2% against 4.4% at the turn of the year.
This should imply that gilts are relatively more attractive, given that inflation is only just over 2% and that short-term interest rates have declined from 7.5% to 5% since last October. But with the economy expanding it is more likely that the Bank of England will raise, rather than cut, interest rates.
Second, corporate bonds yield more than gilts making them an essential component of any income oriented investment portfolio at a time of diminishing returns from deposit accounts. Savers are adjusting their strategies to take into account the prospect of a prolonged era of subdued inflation and low interest rates.
AA-grade bonds yield around 100 basis points more than the equivalent gilt, while yields on sub investment grade bonds in the B category stand on premiums in the range of 400-700 basis points.
Although they carry a higher risk than cash (or gilts) the extent of this risk is open to rational assessment. Thorough research on the fundamentals of bond issuers pays dividends, in the same way as it does for a evaluating a company's shares.
Third, the change dynamics of supply and demand are bound to influence prices at least over short periods. Buyers need issuers and vice versa, but supply and demand do not necessarily match each other at any given time. It is often a case of famine or feast. There has been a surge of sterling corporate bond new issues this year, beginning in March and continuing to date; issuance in euros has been even greater.
Despite increasing demand from both retail and institutional investors there is currently indigestion in parts of the market, which is undoubtedly inhibiting prices. However, looking ahead, equilibrium should be re-established; issuers will be deterred by lack of demand and (possibly) in the third and fourth quarters by year 2000 matters. This should enable investment demand to catch up as buyers take advantage of recent market weakness.
Closer examination of the key fundamentals behind the corporate bond market reveals an attractive outlook, which should not disappoint those savers in search of higher returns in a world where income is increasingly in short supply. The improving outlook for the British economy implies a much more benign environment for companies.
This state of affairs should be especially beneficial for issuers of high yield bonds, with their greater sensitivity to economic trends. Investors should view the recent slight reverse in a positive light. It has deflated some of the earlier hype, but in
no way diminished the mainstream status of the corporate bond market.
Income-conscious investors should seize the opportunity to add to holdings.
John Hatherly is head of research at M&G Group
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