So far, corporate bonds have continued 2003 as they ended 2002. At an index level, positive return...
So far, corporate bonds have continued 2003 as they ended 2002. At an index level, positive returns have been posted. However, stock-specific volatility remains.
On balance this year, macroeconomic data has been better than expected, at least from the UK and US. The housing market, the alleged linchpin for the UK consumer, shows no sign of its much heralded crash. Indeed, the latest figures from mortgage bank Halifax suggest house prices rose by 1.7% in February.
In the US, unemployment at 5.7% remains at lower than expected levels, industrial production appears to be improving and durable goods orders are picking up. Admittedly, US consumer confidence numbers are deteriorating.
In the UK, the market was surprised by the decision to trim the base rate last month. Interestingly, the decision seems based more on international than domestic concerns.
Decent macro data clearly exerts a two-way pull on corporate bonds. A strong economy and the prospect of good earnings growth generally leads corporate bonds to perform.
However, the general level of interest rates tends to move higher, reflected in lower gilt prices. With the OECD forecasting UK GDP and inflation of 2.4% and 2% respectively over the next couple of years, it doesn't look as if interest rates are about to creep up.
Turning to stock specifics, 2003 seems set to be bedevilled with similar problems to 2002. Default levels hit record highs in 2002, 5.3% measured by value according to Moody's, as fraud and general accounting scandals hit home.
Both Moody's and Standard & Poor's expect 2003 to show some improvement, though. Moody's says the ratio of companies on review for downgrade compared to those on review for upgrade has fallen from a 17-to-one high at the end of August to 13-to-one at the end of December 2002. Although this is still high, it is a trend Moody's believes will continue.
Investment decisions based on analysis of fundamentals remain difficult. To exacerbate this problem, if we thought account manipulation was solely a US phenomenon, news that investors in Dutch retailer Ahold were similarly exposed came to light in late February. The price of the company's sterling debt almost halved before a modest recovery.
Creative accounting apart, stock-specific earnings numbers appear to be improving. At the time of writing, we are in the middle of the reporting season for the major UK financial institutions. These continue to constitute a significant portion, not just of equity funds but also of bond portfolios.
On balance, reported numbers appear to be good news for bonds. Although concerns about dividend policy at Prudential, Lloyds and Legal & General may adversely affect the share price, prudent balance sheet management is good news for debt investors.
While the economic backdrop is generally supportive, corporate bonds look decent value, especially compared with 'risk-free' gilts. The average sterling corporate bond currently pays 0.95% more than the average gilt. Five years ago, it was 0.5%, according to Merrill Lynch.
Low growth and low inflation should support corporate bonds, leading to better returns than gilts and cash. Dangers remain at a company-specific level, though. A heavily diversified portfolio, reducing this stock-specific risk, appears an appropriate strategy.
Macroeconomic data better than expected.
Corporate bonds remain good value.
Supportive environment for bonds.
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