The second half of 2000 saw rallies in gilts and investment grade corporate bonds. Even high yield b...
The second half of 2000 saw rallies in gilts and investment grade corporate bonds. Even high yield bonds rallied in December, but can 2001 maintain the same level of fixed income performance?
The fundamentals continue to favour bonds. Gilts and interest rate sensitive investment grade corporate bonds should benefit from the likelihood that the only way is down for UK and US interest rates as data suggests a hard landing in the US and a moderate slowdown in the UK.
Inflation remains controlled: the Retail Price Index excluding mortgage interest is now only 1.8%, its lowest level since records began in 1976.
Gilts should remain well supported by technical factors. The UK budget surplus, which was constricting gilt issuance last year, has now increased even more, further squeezing supply.
The Government has underspent its fiscal target by around £8bn, while the £35bn budget surplus for 2000-2001 is far larger than the pre-budget report's projected £28bn. Even if the Government does splurge on pre-election concessions to the electorate this should not require increased gilt issuance.
Despite proposed corporate bond friendly revisions to pension funds' asset allocation, demand for gilts will continue from private and institutional investors as pension funds move from equities into gilts, impelled by the necessity of providing for an ageing population.
Persistent bouts of equity market volatility suggest investors may continue to favour the safe haven of government bonds.
Fundamental institutional shifts into investment grade corporate bonds have been encouraged by proposed revisions to pension asset allocation over the autumn of 2000, including the amendments to the Minimum Funding Requirement (MFR) by the Board of Actuaries, the release of some of the Myners Report's conclusions and new accounting statute FRS 17.
A National Association of Pension Funds survey confirmed that almost 25% of UK pension funds increased their corporate bond weightings over 2000.
Financial bonds and bonds issued by supranationals, such as the European Investment Bank, should continue to benefit from increased institutional demand for AAA non-gilt holdings in advance of MFR revisions. Securitised bonds should also perform well on investor appetite for the extra security they provide.
There are some storm clouds on the horizon, the darkest of which is the prospect of a US hard landing. Companies issuing investment grade corporate bonds will have to brave a less favourable business climate.
High yield bonds are recovering from their underperformance over much of 2000. Although they have already rallied strongly this year, we are cautiously optimistic the asset class should perform well over the rest of 2001, albeit with some potential volatility.
Jim Leaviss is head of M&G Retail and Institutional Fixed Income
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