Fund manager's comment/Charles Rawson
While poor macroeconomic news and disappointing corporate earnings figures have undermined equity markets, the same newsflow has contributed to rising government bond markets.
Monetary policy in the US, Japan and UK has been accommodating, with a bias in the US and UK towards further easing and the imminent prospect of further cuts in interest rates.
Growth prospects in both the eurozone and Asia have also deteriorated. Recent data releases in Germany, France and Italy have given unequivocal evidence of a rapid slowdown in the eurozone.
Profit warnings are almost a daily event and not likely to abate for some time. There have been a number of severe investment-grade corporate bond blow outs as a result.
While these developments are good for government bonds, the risks relating to corporate bonds have increased. The risk of credit-rating downgrades has increased, not to mention the risk of debt defaults.
On the plus side, however, the monetary easing policies embraced by central banks globally should have the desired effect of averting outright recession and prompting economic recovery by the end of this year. This bodes well for corporate bonds looking forward.
Also, sterling credit spreads are already high historically and arguably reflect the risks referred to above. The flood of corporate debt issues has abated this year, from the telecoms sector in particular.
As a result, investment-grade sterling corporate bond yield spreads over gilts have already contracted slightly. Not surprisingly, the superior credits have tended to see the best performance, whereas high yield spreads have widened as the economic outlook has deteriorated.
As long as the UK economy continues to grow at a steady but controlled pace, there is scope for yield spreads over gilts to narrow, reflecting the corporate sector's eventual improving credit-worthiness in these conditions.
Corporate debt warrants a higher rating in relation to government debt than it did in the financial crisis of 1998. Longer term, with the abolition of the Minimum Funding Requirement, some of the factors that have historically made gilts a favoured instrument for domestic bond investors are gradually disappearing.
With UK inflation under control and not expected to rise significantly in the next few years, the real value of fixed interest payments is far less vulnerable to erosion than at any time in the post-war era.
Investors in sterling bonds should therefore obtain the benefit of a high level of income in real terms with the potential to achieve capital gains if sterling bond yields fall further.
• Poor macroeconomic newsflow.
• Disappointing earnings figures.
• Easing of monetary policies.
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