Last year, investment grade bonds were hit by both rising yields due to the deterioration in the glo...
Last year, investment grade bonds were hit by both rising yields due to the deterioration in the global interest rate environment and a further widening of credit spreads. Will they underperform again this year?
To answer that question, we must ascertain the likely trend in the absolute level of sterling government bond yields, and determine whether credit spreads will narrow or widen.
On the issue of the trend in government bond yields, we are moderately optimistic. Firstly, the trend in inflation is likely to remain benign. We believe that inflation will average no more than 2% over the next two years, and hence stay below the government's inflation target. Nevertheless, this won't stop the MPC from raising rates; our target for the peak in rates is 6.5%. This we feel is broadly discounted by the markets, and therefore should not be a negative factor for bonds. Meanwhile, the continued slump in government bond issuance both in the UK and the US and increasingly elsewhere, is likely to support government bonds for the foreseeable future. Finally, the increasing volatility of equity markets may persuade asset allocators to direct money towards fixed interest securities.
We feel that government bonds yields offer fair though not fantastic value.But what about credit spreads?
The good news is that at the current level credit spreads are at 10 year highs. In fact, allowing for the low absolute level of gilt yields, the ratio of corporate bond yields to gilts exceed the values of 10 years ago.
The second bit of good news is that the demand for corporate bonds is rising. Over the last decade the type of institution that has invested in non-government credit has broadened dramatically, with the low level of government bond yields being the prime mover. In addition, the Minimum Funding Requirement is being reviewed. One option under consideration is whether, in the solvency test, pensions in payment liabilities could be discounted using a corporate bond yield rather than using the yield on long dated gilts. This would mean a takeup in corporate bonds by these institutions.
However, this positive backdrop has been swamped by one very negative influence; namely, the shortage of supply of government bonds, which is in sharp contrast to the heavy issuance of corporate debt. According to figures from Barclays Capital, since 1997, credit issuance has overtaken the supply of government bonds, and this trend is likely to deteriorate further this year.
Another negative factor for corporate bonds is the fear of event risk. The threat of the new economy combined with ferocious competition is forcing management to take extra risk either by acquiring companies, or changing the business profile more directly. In most cases, this has also led to increased financial leverage and hence credit rating downgrades. Corporate bond spreads are likely to remain wide, primarily due to the lack of gilt issuance, and abundant supply of credit. However, demand for credit will rise.
Edward Bacon is director at Scudder Threadneedle Investments
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