An increase in the number of companies shifting their pension funds from equities to bonds has prompted fears that demand may soon outstrip supply, leading to a dilution in the overall quality of bonds available
Boots, the high street chemist caused a stir last year. But it was not a new range of cosmetics or a fantastic product launch. It was not a huge growth in stores or meteoric profits nor an acquisition or merger. Remarkably, it was Boots' decision to move its £2.3bn pension fund from equities into bonds.
The move was not entirely surprising ' bonds had been offering improving returns since the summer of 2000, at a time when equity markets were hit by post dot.com uncertainty and atypical world events. In particular, investment grade corporate bonds (rated BBB or above) have outperformed gilts and equities. Boots moved into long dated AAA-rated sovereign and supranational bonds, which should offer a 0.5% spread above long gilts.
But while bonds have looked strong, they can be severely impacted by changes in inflation. While inflation has remained remarkably low over recent times, in 2002 underlying inflation jumped above 2% for the first time since 11 September, fuelling speculation that interest rates may rise. With this in mind, are bonds likely to remain as attractive?
There is no doubt that bonds have been relatively successful over the last year or so, which has been reflected in their high representation in sales. Indeed, in February 2002, net sales were £293.4m in the UK corporate bond sector, as opposed to £116m in the UK All Companies sector.
Moreover, UK corporate bonds have been the strongest performing of all the bond sectors over the last 12 months, which has resulted in many investors moving their funds into them. This presents a dilemma ' there are limited quality bond opportunities available and demand is far outstripping supply. The concern is that to fulfil that supply, more low calibre bond opportunities will be promoted into the market. This in turn will dilute the quality of the market, leading to worse sector performance and negative consumer sentiment.
The demand for bonds is likely to be fuelled by the FRS17 accountancy disclosure rules, which force companies to value pension funds at current market value. Actuarial calculations are designed to incorporate capital growth over long periods of time, taking into account market fluctuations.
However, market value disclosure means pension fund values can be depressed if equity markets have been underperforming. To avoid reporting depressed values on balance sheets, this has encouraged companies to invest in less volatile bonds.
However, the failure of a number of high-profile companies, such as Enron has lead to uncertainty creeping in for corporate bonds. This in turn has lead to many corporate bonds trading at a discount and offering excellent yields. As the world economy recovers, so corporate bond prices could rise.
Fund managers have been quick to reassure investors that Enron is an isolated incident, and is not likely to repeat itself, but with profit warnings up 10% in the quarter to December 2001 according to Ernst & Young, there may be further fears of default. That said, some predictions have shown that the global bond default rate (which is currently around 10%) will decline to 7.2% by January 2003.
Nonetheless, there is evidence to suggest that the high yields offered by corporate bonds cannot be attributed solely to the greater risk of default. The impact of default can only explain a yield spread of tenths of a percentage point between corporate and government bonds, while actual spreads are two or three percentage points.
It has been argued that the spread difference is created by the same factors that influence equity returns ' this is indicated by a close correlation between the performance of small stocks and the yields offered by corporate bonds.
Furthermore, there is mounting evidence that corporate bond yields are correlated with equity volatility.
This is hardly surprising considering high share price volatility is indicative of uncertainty over the company's inherent value, which in turn should make a company a more risky investment. This in turn should increase the chance of default and hence the risk. This should raise the yield to compensate investors for the potential risk.
This presents an interesting consideration for most advisers. Bonds and the risks associated with them may indeed follow stock market trends far more closely than thought, rather than being immune to equity pressures. Advisers will thereby compelled to consider equity risk in any assessment of bond prospects.
Furthermore, advisers should consider the cyclical nature of bond markets in any recommendation. Defensive sectors such as supranationals, which performed well during 2001 are likely to have worse performance in 2002 if economies recover as expected. In contrast, high yield, higher risk bonds, which typically have a positive correlation with equity performance, may fare better as markets recover their poise. Some commentators have also suggested that low interest rates should benefit consumer sectors in 2002, leading to stronger high-yield opportunities.
Views remain mixed as to which sectors will offer the best returns over the next year. As discussed, the consumer sector may take a positive knock on from low interest rates stimulating consumer demand. Equally, the financial sector, which was impacted so adversely by last year's events in America, may start to show stronger signs of recovery. Equally, high-risk investment grade bonds, of BBB or A rating might be worth investing in, as the economy shows the first sign of recovery. For more aggressive investors, BB or B bonds may present excellent returns with great risk attached, and for the risk junkie, CCC-rated bonds may present opportunities, though this is junk bond territory.
AAA and AA bonds, which have provided safe returns over the recent period of economic uncertainty, may not be as attractive a proposition if markets start to pick up this year. Indeed, as the economy starts to recover, bonds may well be overlooked as investors choose equity based investments, to benefit from rapid rises in recovering markets. Indeed, indications over the past couple of months show that equities are outperforming bonds again, while corporate bond funds have suffered falls in value.
But many investors have been burnt recently by the dot.com boom and bust and an incredibly difficult 2001. For those who feel they are not quite ready to brave the roller-coaster ride of equity markets again, corporate bonds may provide security of investment. And with default rates projected to fall, risk-averse individuals, in the same way as Boots, may well find that the certainty of bonds is an investment well worth investigating.
With demand outstripping supply, the concern is that more low calibre bonds will come to the market.
Some predictions have shown the global bond default rate will decline to 7.2% by January 2010.
Defensive sectors such as supranationals are likely to underperform in 2002 if the economy recovers as expected.
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