The sharp correction and increased volatility in equity markets last March impacted negatively on co...
The sharp correction and increased volatility in equity markets last March impacted negatively on corporate bonds. As well as adding to uncertainty in the corporate environment, it increased the leveraging effect on company's balance sheets by increasing the level of debt relative to the market value of equity.
The leveraging effect on their debt-to-equity ratios in turn undermined creditworthiness, especially for companies that already had high levels of debt, and increased the premium investors required in order to hold corporate bonds.
Another factor that had a negative impact on the sterling credit market was the Government's auction of 3G mobile telephone licenses in April.
This raised £22bn but forced telecom companies back to the markets to raise additional funding for developing largely unproven technology. Telecom companies started 2000 with high levels of borrowing after previous consolidation and, as the year progressed, were forced to raise more money from the global capital markets.
This resulted in a large increase in supply that helped to contribute to widening spreads. By year-end, most of the large telecom companies had seen their credit ratings downgraded.
Sentiment turned around in the second half, driven in large part by a more positive interest rate outlook. The interest rate cycle clearly appeared to have peaked in the US and UK as growth slowed and an increasing number of cyclically sensitive companies announced corporate earnings downgrades. Most significantly, shorter dated yields fell in anticipation of rate cuts and led to resurgent interest in corporate bonds.
A hard landing in the US could lead to a renewed global credit crunch in terms of lenders refusing to buy bonds at any yield. However, given the Federal Reserve's interest rate cuts in January there is every possibility rates will continue to be cut to sustain growth.
The publication of several consultation papers relating to the Minimum Funding Requirement (MFR) review proved a major factor behind the recovery of corporate bonds. Defined Benefit schemes still make up 80% of UK pension assets under management and so possible changes to MFR will have a huge impact on gilts and corporate bonds.
The present MFR scheme requires the pension payment element of pension fund liabilities be discounted at a rate equivalent to a nominal 15-year gilt. In a recent paper, the Institute of Actuaries suggested using the yield of corporate bonds as the discount rate for current funding obligations for all liabilities. The Myner's report was more far-reaching and suggested the total abolition of the MFR with funds also able to invest in venture capital. Myners argues that the MFR distorts pension fund's investment decisions in favour of gilts but provides very little protection for DB scheme members against under-funding or fraud. In its place, he suggested greater emphasis on transparency relating to trustees' investment assumptions backed-up by tougher controls on fraud.
Changes to the regulatory environment combined with falling interest rates are highly likely to have a positive effect on corporate bonds and lead to further narrowing of the yield differential over gilts, especially in double A and triple A rated credits. It will also take the pressure off the gilt market.
Shifts in demand for credits are unlikely to present structural problems in terms of supply despite the combined market of sterling eurobonds and domestic bonds being currently much smaller than the gilt market. Structural factors have dominated the gilts market and contributed to spread widening, which has been particularly distortionary at the long end.
Gilt supply is dependent on the Government's borrowing requirement to fill the gap between tax revenue and public expenditure. At present, the large budget surplus means the Government has no need to increase net issuance. Obviously, an economic slowdown and the Government's commitment to large spending initiatives will lead to an eventual increase in issuance, which will lead in turn to higher gilt yields and a steeper yield curve.
There is also every indication that corporations will come under pressure from shareholders to increase the amount of debt used to run their businesses. At present, UK and European corporations lag behind their US counterparts who have come under pressure to increase the return on equity through increased leverage.
Gavin Boyd is a fund analyst at Fidelity Investments
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