With interest rates low and inflation under control, investors can expect the decent yields they have been getting from the fixed-interest market over the past three years to continue
It has been a good time to be a corporate bond fund manager, with credit outperforming equities for the third consecutive year as stock markets continue to suffer the worst bear market since 1974.
The key to whether corporate bonds can continue to deliver decent performance levels is inflation. Rising inflation is an enemy of corporate bonds as it erodes their real value, but I believe that the current low level can be and will be sustained.
I am also not one of those in the deflation camp. There has been increasing speculation that deflation -' when there is a general fall in prices fall levels, rather than a rise ' is becoming a greater risk to the UK economy. It is a very rare phenomenon and one that has not been experienced in the West since the 1930s and my own feeling is that Britain will escape the deflation trap, although Germany may not be so fortunate. We have areas of stubborn pockets of inflation, notably in the property and service sectors, which will help offset sectors that are facing deflationary pressures.
The fact that the price of many high street goods has been falling does not necessarily mean that we are moving toward a deflationary environment.
Rising interest rates are often bad for corporate bonds, since this tends to reflect a central bank's response to a deteriorating inflation outlook. At present, however, the economic outlook indicates that a series of interest rate hikes is unlikely.
There is no doubt that the Monetary Policy Committee is conscious of the danger of runaway house price inflation, but it is also acutely aware of the slowdown in global demand, the current precarious lacklustre performance of the industrial sector and the lack of business investment that is occurring.
There is already some evidence that house price inflation may be slowing down of its own accord, in areas such as London and pockets of the south-east, and if house price inflation continues to run out of steam of its own volition, the MPC will not be forced to raise rates.
If house price rises were to continue unabated however, then whatever happens, the MPC must continue to show that it has the overall economy under control. If it looks as though it was acting too late by allowing inflation to get out of control, government and corporate bond yields would rise.
Corporate bonds have benefited from the turbulent equity markets as private and institutional investors, particularly big pension funds, have sought safer havens. Figures from the IMA show that corporate bond funds are among the most popular sellers. This has led companies such as Boots and Scottish Power to significantly increase their exposure to corporate bonds at the expense of equities in the past couple of years. And this demand for corporate bonds looks is set to remain strong.
The pressure on pension funds is intense. They have now suffered their worst period of performance since the mid-1970s, according to the latest figures from Russell/Mellon CAPS, an investment information group. They show that the value of UK pension funds has now fallen for three years in a row for the first time since records began. Funds fell by about 11.3% last year, following a drop of 8.9% in 2001 and 1% in 2000.
Pension funds have a different agenda today than in the 1990s when the cult of the equity was at its height. Performance then was all about beating your peer group, which meant encouraging higher equity weightings. The downturn in markets has forced funds to give greatest import to their own asset/liability positions and be less concerned with tables of relative performance.
This shift of emphasis, and the resulting increased demand for bonds is likely to remain in place, resulting in a flight to safety.
Many insurers are also being forced out of equities into bonds to bolster solvency requirements laid down by the Financial Services Authority. It is not just volatile stock markets that are boosting demand for bonds.
The proposed removal of the minimum funding requirement for pension funds will also stimulate demand, as should the new accountancy rule, FRS17, which forces companies to reflect fluctuations in the value of the fund in profit and loss accounts.
Last year was a difficult year for investors in high-yield or so-called junk bonds, with a record amount of downgrades and defaults. Defaults had reached a record $157.3bn last year, up from $117.4bn in 2001, according to Standard & Poor's. Of the total defaults, $123.6bn came from the US and $14.6bn from the European Union.
There is a theory that once default rates have peaked, a boom in the high-yield bond market swiftly follows. There has indeed been a good rally in high-yield bonds in the last few two months, but you have to remember that there is still a lot of highly indebted companies on the market operating in competitive and risky environments.
We are not out of the woods yet. There are certain to be a few more unpleasant surprises on the corporate front or continuing downgrades.
Within investment grade bonds, corporate indebtedness remains high in certain areas, particularly car manufacturers and in sectors such as the water industry and other utilities. But the landscape is changing. The overall appetite for debt is reducing and some companies that have gone through the mill, such as BT, now appear to be back on track. Market volatility throws up opportunities. The insurance sector, for instance, has been undermined by questions of solvency. Towards the end of the year I increased positions in life assurance bonds and if, as I believe, equity markets prove to be more stable this year, life assurance bonds will continue to offer value.
I bought some Standard Life bonds in October. At the time there had been a strong rally in the equity market, but the credit spread on the bonds had remained wide. This seemed inconsistent, since solvency concerns lessened as the equity market rallied, while the level of credit spread also appeared to have priced in a lot of nervousness towards the sector and so seemed to offer intrinsic value.
I am also looking for sectors with more stable earnings, for example, companies in the general retailing, food retail and tobacco sectors.
The telecoms sector, in particular, is expected to recover its poise after the turmoil of the last few years. It began its recovery in the second half of last year. I held BT bonds throughout 2002, and added the AA-rated Telstra bonds ' the large Australian operator ' in July. The progress made by European telecom companies in reducing their debt has in general been better than expected and many will continue to make progress in getting their debt levels down.
One area to avoid is auto-manufacturing debt, because debts at companies like Ford have caused management problems. I would expect credit spreads to remain wide in this sector while managements at companies such as Ford and GM seek to fulfil their heavy refinancing requirements.
While equity markets remain volatile, bond markets are likely to remain low and inflation stable over the medium term. Gilt yields are likely to trade in their current range between 4.5% and 5%. Corporate bond spreads may have narrowed in the past few weeks, but they still offer good value in terms of history and offer reasonable compensation for taking on company risk.
While the corporate bond market is not astoundingly cheap at present, it is still reasonably attractive based on longer-term historical comparisons ' particularly bonds with maturity dates of between seven and 10 years.
In terms of high-yield, much of the carnage that has occurred, particularly in the second-line telecom and cable companies, suggests that the worst may be over in terms of defaults. This gives scope for some cautious optimism, but this market by its nature remains high risk.
There is also a feeling within the corporate sector that, over the past few years, debt was allowed to build up to excessive levels. Companies seem now to be taking a more responsible attitude by emphasising debt reduction.
There has, over the last five years, been a revaluation of bonds both in absolute terms and relative to equities. Much of this revaluation can be put down to a better macro-economic policy delivered by the MPC.
It has resulted in sustainably lower inflation and a much lower perceived risk of higher inflation returning to erode bond returns. My instinct is that this newly established valuation basis for bonds is sustainable.
Going forward, my feeling is that, over the longer term, equities will outperform the corporate bond asset class but not to the same extent as they did during the high inflation periods of the second half of the last century.
Over the next 12 months, however, it could be a close run thing.
Corporate bonds, buoyed along by the low interest rate and low inflation environment, will in my view, continue to deliver the goods to investors in terms of a decent yield and relatively stable capital values.
The key to whether corporate bonds can continue to deliver decent performance levels is inflation
The fact that prices of many high street goods have been falling does not necessarily mean we a moving towards deflation
While the corporate bond market is not astoundingly cheap, it is attractive based on longer-term historical comparisons
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