The widely forecast slowdown in corporate bond issuance in the final quarter of 1999 failed to mater...
The widely forecast slowdown in corporate bond issuance in the final quarter of 1999 failed to materialise. Instead, ongoing merger and acquisition activity in a wide variety of sectors fuelled a continued requirement for companies to raise money.
Meanwhile, receding millennium bug fears further encouraged the issue of corporate paper. With the UK's inverted yield curve adding to the attraction of sterling-denominated bond issuance, the flow of new issues has continued unabated.
At the same time, the government's excellent funding position has meant that gilts have been in short supply in recent months, while the Minimum Funding Requirement has increased institutional demand for long-dated government bonds. The resulting imbalance between demand and supply has led to very strong performance from long-dated gilts in recent weeks with the yield on the 30 year benchmark bond briefly touching 4%.
These technical factors have resulted in a widening of corporate bond spreads which has left them at attractive levels given our long term economic views. Among the bonds that we have added to the portfolio are issues by food service company Compass Group, brewer Alehouse and rail company West Coast Trains.
However, while there has been no shortage of new issues to choose from, in general we have found little of interest and these bonds represent examples of the 'cherry-picking' strategy that we have employed. Instead we have invested the majority of new cash in government stocks, which has been positive for performance while helping to keep the average risk rating of the Threadneedle UK Corporate Bond fund above its target of A-. We also have a strategy of searching for good value while avoiding negative event risk. This is illustrated by the financials sector, where the risks include the ongoing erosion of margins through increased competition and the adoption of internet banking. We believe that the risks are already reflected in the price, however, and the sector is among the most attractively valued. We have recently added to our exposure by increasing our holdings in Lloyds TSB and US company Citigroup.
With companies remaining under pressure to return value to their shareholders via share buybacks and corporate activity, the resulting increase in gearing has led to deteriorating credit ratings in some areas. Similarly, the low growth, low inflation backdrop has made for a difficult trading environment for many mid-range retailers - as evidenced by recent profits warnings from companies such as Marks & Spencer.
As the spread of the internet into the retail masses allows consumers to compare prices more easily, pricing pressure is likely to remain a feature and those companies that fail to adapt to the changing retail environment will become vulnerable to downgrades. With this in mind, we have been wary of retail names, preferring to concentrate on those with a dominant market position such as Tesco.
The outlook for investment grade debt is reasonably positive. Although issuance is likely to remain at high levels, the economic background is favourable and the review of the Minimum Funding Requirement legislation in the spring may lead to an increase in demand for high quality corporate issues.
Laurence Mutkin is head of fixed interest strategy at Threadneedle Investments
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