Bond markets, both corporate and government, are being affected by the determination of the central ...
Bond markets, both corporate and government, are being affected by the determination of the central banks of the US, UK and Europe to act pre-emptively against inflationary pressures.
Although inflation rates in the major economies are currently very low, there have been multiple warnings of pressures beginning to build within the global economic system. In the US, we have seen a further 0.25% interest rate increase this month, and Alan Greenspan has again expressed concerns about the buoyant equity market fuelling unsustainably strong consumer demand.
In the UK, despite an inflation rate among the lowest in Europe, house prices, real earnings, and producer input prices are all rising sharply. Within the Eurozone, the European Central Bank raised interest rates this month from 3.25% to 3.50%, because upside risks to price stability were seen as a reason for vigilance.
Globally, we are seeing continuing, or strengthening, economic growth.
A not unusual reaction to rising short-term interest rates, and the expectation of higher rates to come, is a widening of credit spreads within corporate bond or 'risk' markets. There has been a significant widening of credit spreads in the US corporate bond market, although this has been less evident within the Euro high-yield market.
There are a number of factors contributing to this. Real interest rates in the US are significantly higher than in the Eurozone, and likely to move higher still. US companies, as a group, are generally more leveraged than European companies.
The principal source of new supply in the Eurozone, telecoms, is benefiting from positive equity investor sentiment. Meanwhile, the Eurozone bond market is experiencing rapid growth of demand. Companies are seeking to make more efficient use of capital, and are raising this on an 'as-needed' project-specific basis, rather than retain dormant.
Deregulation is providing opportunities for new start-ups, and European corporate activity is at record levels, all of which generates need for finance. The widening of spreads has been more evident at the long end, where yield curves in both the US and UK government bond markets have inverted. These inversions have been driven, in the US, by fears of shortage of supply as the Treasury utilises the budget surplus to buy back debt and, in the UK, by the so-called Minimum Funding Requirement, which has stimulated pension fund managers to buy long-dated gilts, almost regardless of price.
In a rising interest rate environment, prospects for capital gain recede, and income becomes the dominant factor in overall return. We prefer corporate bond markets to government bond markets and, in particular, the European high yield market.
Paul Causer is joint head of fixed interest at Perpetual
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