Corporate bonds look set to outperform gilts in 2002, as global markets tentatively head toward anot...
Corporate bonds look set to outperform gilts in 2002, as global markets tentatively head toward another growth cycle.
With interest rates likely to rise throughout the year, opportunities in shorter-dated bonds could emerge as the market prices in the forthcoming monetary tightening overzealously.
Will Hay, head of fixed interest at Standard Life Investments, says: 'Bond markets have priced in a great deal of monetary tightening over the next 12 months. Interest rates could stay lower for longer than markets expect, which will be positive for the short end of the yield curve.'
Hay says given that UK and US economies are experiencing record low interest rates, the interest rate cycle has almost certainly bottomed. The reaction of bond markets to this has been too fast and too stark, as interest rates will remain low for some months, he says. This should provide opportunities as the market corrects its forecasts accordingly.
Andrew Clare, financial economist at Legal & General Investment Management, believes the key driver behind the outperformance of corporate bonds this year will be the improving credit quality of UK firms he expects to accompany the market upturn.
Clare says: 'As the UK economy improves over the year, so too should the average credit quality of the corporate bond market. Improving credit environment and anticipated strong demand for this asset class could mean corporate bonds move from a current average spread of about 1% to Government bonds to test the 0.7% levels seen in the late 1990s.'
He adds that a portfolio of corporates where spreads tightened by 0.35% over a year, would outperform gilts by 4% a year. Although the outlook for fixed interest as an asset class has waned relative to the past 18 months, corporate bonds should still benefit from the anticipated gradual increase in company profitability this year and continued strong demand, largely because of structural reasons. Hay says pension fund demand and solvency considerations for life assurers will continue to support fixed interest markets, particularly in the UK and Europe.
Mark Capleton, a gilt strategist at Barclays Capital, says the tightening of gilt spreads relative to European government debt is providing the opportunity for profit taking.
Capleton says: 'Given the gilt spread tightening we have seen, it is now time to take some profits. Against Euribor, 30-year gilts and bunds trade within a few basis points of each other, so long end convergence seems more or less complete.' He also anticipates similar homogenising of returns between gilts and European government debt, on the back of the Government's dwindling coffers.
Capleton notes: 'Deteriorating public finances in the UK should prove helpful for swap convergence at the short end of the curve, where discrepancies with the eurozone are still large. The issuance of more UK Treasury Bills and the first short-dated gilt issue since 1999-2000 will help boost the pool of short-dated, risk-free collateral, which should reduce its scarcity to premium.'
He adds that uncertainty about whether the UK will enter the single European currency continues to deter managers from the long end of the bond market.
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