It is a supreme irony that just as corporate bonds are achieving both a higher profile and real crit...
It is a supreme irony that just as corporate bonds are achieving both a higher profile and real critical mass on this side of the Atlantic recent returns from them have been so lacklustre
This is readily explicable, given the weakness of fixed income markets in the face of accelerating growth and the uncertainty over the extent of rates rises needed to stem the tide of inflationary forces. However, a number of short-term factors have conspired to complicate the picture and obscure the longer term case
Corporate bonds are sensitive to interest rate changes, although to a lesser degree than government stocks. We estimate that, as a rule of thumb, the sensitivity of investment grade corporate bonds is 80% to interest rates and 20% to company credit risk, while for high yield stocks a 50% split is more accurate. Gilt yields have risen since the start of the year, with a knock on impact on other fixed income stocks. Uncertainty seems likely to persist in the near term, but unless some of the gloomier predictions come to pass, current yields appear defensive
The popularity of corporate bonds for issuers and investors alike is having a double edge effect. The plethora of new fund launches testifies to the underlying growth in demand, especially from the retail sector. It has helped to stimulate much greater issuance, with the advent of the euro encouraging European companies to follow the US and UK examples. Supply and demand moved out of balance during the summer and market indigestion has undoubtedly impaired the recent performance of corporate bonds. However, the volume of new issuance in September was below expectations and, if this trend continues, a better balance will be restored, enabling yield spreads over gilts to tighten
The millennium is a further near term source of uncertainty and issuance is likely to diminish in December and January
The longer term case for corporate bonds is still intact for the following reasons: the yields on offer are very attractive, either in nominal or inflation adjusted terms, for the growing constituency of income seeking investors; A-rated investment grade corporate bonds yield more than 1% above the equivalent gilt while BB (sub-investment grade) stocks yield a further 2% or so
Unless interest rates rise significantly above their current 5.25% level, returns on cash will remain uncompetitive for savers prepared to accept the risk profile of corporate bonds. With stronger economic growth boosting company profitability, underlying prospects for most corporate issuers should improve. In contrast to a year ago, yields on fixed income stocks now stand at levels which discount a great amount of bad news. The same cannot be said for equities. Real yields on investment grade corporate bonds of around 4% should prove defensive, especially if the mood of investors turns even more cautious
John Hatherly is head of research at M&G Group
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