By Jennifer Chirrey, a fund manager at Abbey National Asset Managers This year has been one of t...
By Jennifer Chirrey, a fund manager at Abbey National Asset Managers
This year has been one of the most challenging and volatile for bond investors in all asset classes, with such names as WorldCom, Tyco and Ericsson all falling into the sub-investment grade category.
Before this there had been extremely strong technical demand for sterling corporate bonds. Falling equity markets have forced insurers to review equity backing ratios to maintain solvency ratios and pension fund trustees to increase bond weightings to maintain the minimum funding requirement. This has resulted in an increase in demand for sterling corporates and sparked interest from non-traditional investor sources. This resulted in significant outperformance of corporate bonds relative to UK gilts.
This demand has seen a huge expansion in the market over recent years. The Over 5 Year Sterling Investment Grade Index currently comprises more than 500 stocks and has a market cap of £173bn. Indeed, by November 2001 the market cap of this index overtook that of the Conventional Gilt Over 5 year index for the first time.
Since then the gap has continued to widen as corporate treasurers look to take advantage of the historically low level of absolute yields by issuing bonds in the sterling market.
This huge growth in the corporate bond market has meant the overall credit profile has decreased as more lower-quality names are brought to market. Corporate treasurers are tempted by historical low yields and strong investor demand. However as the investor base is insisting that they obtain credit ratings to access markets, this has resulted in an increase in lower-quality ratings.
The deterioration in the credit profile has been further exacerbated by the general deterioration in credit quality. Another trend is a growing correlation between movements in equities and bond spreads, with credit investors viewing a weakening share price as an early sign of problems.
The above factors, when combined with negative credit stories and consequent spread blowouts, have caused panic among investors who have since become more risk-averse. Examples include investor concerns over debt mountains at France Telecom and Deutsche Telecom, British Energy admitting solvency problems, TXU walking away from its European operations and, most recently, ABB's problems.
Chunky supply from the financial and utilities sectors also appeared to saturate demand and since then supply pipeline has been extremely light with only the best corporate names able to issue.
Stock selection and a lower risk appetite appear to be the key criteria in the decision making process.
Prospects seem cautiously favourable. Corporates will be focusing on deleveraging and a build-up of institutional cashflow, asset allocation switching out of equities and an increase in pension fund bond mandates will ensure investor demand.
We favour an extremely diversified single A and triple B portfolio where exposure to individual names is diluted yet returns will be more attractive as opposed to a low-yielding, risk-averse triple A portfolio.
Demand for higher yielding paper.
More stable markets will help confidence.
Companies will focus on debt reduction.
Lower-grade names coming to market.
Risk of negative corporate newsflow.
Growing impact of hedge funds.
Two global vehicles
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