We are living in interesting times for the UK fixed interest markets. In the middle of September the...
We are living in interesting times for the UK fixed interest markets. In the middle of September the Government released their long awaited review of the Minimum Funding Requirement inviting the general public to submit suggestions and engage in debate surrounding the proposals for reforming this disliked solvency measure. Ironically the suggestions made in the report accentuated some of the distortions that have resulted from its current form.
The switch to a bond related yield to discount immature liabilities could encourage pension funds, whose funded position with regard to MFR thresholds is precarious, to buy more gilts as well as corporate bonds. This could potentially reduce further the long run returns of these schemes. Both gilts and corporate issues reacted well to the publication and, in particular, the proposal to switch to a more diverse spectrum of maturity looks set to flatten (disinvert) the yield curve over time. However the timing of any implementation of interim measures is uncertain and the large fiscal surpluses overhanging the gilt market will lead to periodic bouts of extreme demand /supply mismatch.
From a macro-economic perspective the recent increase in the oil price has created divergent opinion surrounding the near term direction of monetary policy. Some investors believe this is beneficial for base rates, as the growth inhibiting nature of an increase in the cost of energy will outweigh the inflationary consequences. On the other hand while oil prices remain high will the world's central bank authorities be disposed to accommodating any potential inflationary pressure, by easing into this cost push shock? Probably the answer, as usual, lies somewhere in between.
It would seem that most of the action is likely to be witnessed in the corporate bond market where the proposal to switch to a hybrid corporate/gilt index to establish the discount factor within the MFR will encourage investment. However there are risks here too. Within the next couple of months we are likely to see the publication of the Myners review on pension fund investment which may suggest scrapping the MFR altogether which may obviously affect bonds in total but corporate issues more so, given their relative illiquidity. In addition if the growth outlook deteriorates substantially the credit worthiness of corporate issuers will come under scrutiny.
This will be particularly true of those BBB rated securities that have been included within the potential universe due to their investment grade status. These bonds could be subject to the event risk that they become ineligible simply because of a single 'notch' downgrade.
It looks like the summer torpor of both gilt and corporate bond markets is behind us and we are in for sustained volatility over the next few months. Medium dated good quality corporate bonds should outperform.
Mike Turner is head of global fixed interest at Edinburgh Fund Managers
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