In recent weeks, financial markets have been preoccupied by geopolitical factors. Moreover, the e...
In recent weeks, financial markets have been preoccupied by geopolitical factors.
Moreover, the economic impact of any conflict is extremely difficult to quantify. Certainly, investors in corporate bonds could be forgiven for remaining somewhat nervous in this environment, bearing in mind the already fragile state of the world economy and the squeeze on corporate profitability.
However, it is all too easy to overlook the fact that there are some positive forces in play which augur well for corporate bond markets in the longer term. Investors have already begun to recognise the efforts a number of companies have made to repair their balance sheets, through offloading non-core subsidiaries and cutting costs.
Some prominent examples can be found in the telecom sector, where major providers such as British Telecom have sought to improve their credit quality through debt reduction. Indeed, this sector was the best-performing area of the sterling corporate bond market over the first quarter of 2003.
Historically low interest rates, with the very real prospect of further reductions in the UK and Europe, also provide support for corporate bonds, as all but the most conservative income-seeking investors look for an alternative to cash deposits and low-yielding gilts.
In addition, low interest rates provide a favourable environment for financial sectors and in particular banks, as the low cost of borrowing encourages lending and boosts operating margins. In particular, we believe that top-tier UK financial players such as HSBC and Alliance & Leicester are well-placed to capitalise, as they are less plagued by bad debts and have stronger balance sheets than many of their Continental European counterparts.
Aside from economic factors, we believe that a number of structural issues are key positives for corporate bond markets. Most notably, there is the changing regulatory landscape for UK pension funds with the proposed abolition of the minimum funding requirement and the introduction of the new accounting standard FRS17.
This may trigger more demand for sterling-denominated investment-grade corporate bonds from UK institutional investors looking to adopt an investment strategy that is more commensurate with the nature of their existing and future liabilities.
Nevertheless, the economic outlook is clearly a cause for concern. Recent consumer confidence surveys in both the US and the UK have been very disappointing and retail sales have been notably weak. Sentiment among businesses is also fragile as companies hold off from investment plans until the geopolitical background becomes clearer.
While a near-term conclusion to the war in Iraq may well trigger a rally in financial markets, it is likely to be some time before confidence returns and any recovery in economic activity is likely to be subdued by historical standards.
Investors in corporate bonds must beware of the risk of further ratings downgrades as companies continue to adapt to the low growth, low inflation environment, particularly in more cyclical sectors and industries subject to pricing and regulatory pressures, such as utilities.
While we are positive on the longer-term outlook for corporate bonds, we believe markets are set for a bumpy ride and avoiding the pitfalls is just as important as spotting the best investment opportunities.
Companies continue to repair balance sheets.
Low interest rates.
Increased interest in corporate bonds.
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