Spreads on investment grade sterling corporate bonds have been widening since March 1997. During tha...
Spreads on investment grade sterling corporate bonds have been widening since March 1997. During that period the market has increased from £93bn to £165bn by the end of the first quarter of 2000 while the gilt market has grown by only by 3% to £239m. The trend has continued and spreads are now substantially wider than they were at the time of the Russian crisis and hedge fund problems in late 1998.
Recent studies have shown a strong correlation between corporate spread widening and growth in corporate issuance, and a similarly strong correlation between shrinking government supply and widening swap spreads. Faced with increasing corporate issuance and shrinking government supply, does it make sense for UK bond fund managers to increase or maintain their exposure to credit?
The decision to invest in corporate rather than government bonds is driven by the expectation that they will provide a greater risk-adjusted return over the holding period. Spreads on investment grade bonds are in excess of the level needed to compensate for default risk. So on average, buying and holding until maturity will provide a greater return then holding government bonds. But many funds are concerned with shorter periods and will attempt to fine-tune their purchases.
In a bear market break-even analysis can be useful. It assesses the degree of downside protection built in to the spreads on bonds or market sectors. It establishes the amount by which a spread can widen before the bond/sector would underperform its benchmark gilt. Short duration/large spread bonds offer the greatest protection.
Assuming unchanged gilt yields, if you invested in a AAA-rated five-year bond, at a spread of 70 basis points it could widen by 21 basis points over a year before underperforming its gilt benchmark. But a 30-year AAA-rated bond bought at a spread of 120 basis points could only widen by 10 basis points as its longer duration would outweigh the wider spread. The larger spreads available on bonds with lower credit ratings provide greater break-even protection.
Once break-evens have been established for bonds or sectors, they can then be compared with the average spread widening. Since March 1997, five-year AAA-rated bonds have gone from two to three basis points over gilts to around 70 basis points. So if you bought an AAA-rated bond at a spread of 70 basis points, and over the next year it widened at the recent average rate, you would get the same return as holding the benchmark gilt.
The 30-year AAA-rated bonds have widened from 30 basis pointsover gilts to around 120 basis points, an average of about 30 basis points a year. Because of their longer duration the break-even protection is much less at around 10 basis points. So if you bought 30-year AAA-rated bonds at 120 basis points over and they continued to widen at the average rate they would under-perform the benchmark gilt by around 2.5% over 12 months.
Kathryn Wood is investment manager, corporate bonds at Abbey National Asset Managers
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