Bonds have been the silver lining to the equity market's dark cloud for some time. Just as 2002 was ...
Bonds have been the silver lining to the equity market's dark cloud for some time. Just as 2002 was the third year in a row that equity markets fell it was also the third year of positive returns for the gilt market and sterling corporate bond markets.
This rally has been accompanied by increased allocation to bonds by many institutional investors such as insurance companies and pension funds. Retail investors have also been strong buyers of corporate bond funds in particular.
Looking forward, I believe that much depends on the housing market.
The boom in house prices is both symptom and cause of the continued strength of consumer spending and is the main reason that the UK has the healthiest economy in the G7.
Should house prices stop rising or even fall, I expect the Bank of England to quickly cut interest rates further and bonds to do well.
The other major factor is the global equity market, which has shown signs of stabilising recently. If this proves to be more than a bear market rally then the shine may come off gilts. However a stable stock market would be good news for the growing corporate bond market and high yield bonds in particular.
One word of caution: government finances are deteriorating after a long period of bond-friendly prudence and this will lead to a strong supply of gilts in 2003. While we believe that this supply will be easily soaked up by institutional investors, this factor is worth watching.
Paradoxically, while the headline stories have often been calamitous (WorldCom, Marconi, Enron etc) 2002 was a superb year for corporate bonds. The horror stories emphasise the need for a diversified portfolio and employing a manager with a solid investment process.
While the main determinant of the market's fortunes in 2003 will be the gilt market, corporate bonds are also affected by company profitability and strategy. Many companies are concentrating on reducing debt and are cutting capital expenditure and avoiding acquisitions towards doing so.
The Merrill Lynch Non-Gilts index's yield fell from 5.84% to 5.25% over the year. While this may not seem hugely exciting, it still exceeds what one gets at the building society and looks reasonable so long as inflation stays low.
Offsetting the modest return is the huge positive of low volatility compared to equities and this should maintain a healthy interest in the market. There is also a trend towards beefing up yields by allocating some money to the high yield market. Institutional investors are investing directly in high yield funds while retail investors are more inclined towards hybrid funds with a balance between investment grade and high yield.
Our conclusion is that corporate bonds deserve a place in most investors' portfolios. Their attributes of steady income and good performance in difficult economic circumstances are complementary to the capital growth offered by equities.
Look to well managed corporate bond funds to offer a better yield than gilts or building societies can deliver. High-yield funds offer still higher yields but are also higher risk.
Inflation expected to stay low.
Superior income to equities.
Companies focusing on reducing debt levels.
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