BY Michel Gonnard , head of global fixed interest at Cazenove The UK corporate bond market was p...
BY Michel Gonnard , head of global fixed interest at Cazenove
The UK corporate bond market was particularly challenging to analyse during June. At first glance, corporate bonds performed particularly well, with a total return of 1.8% (capital plus income).
However, closer observation shows the capital gains for the month can be attributed as follows: 1.9% from the performance of the underlying gilt market and -0.9% for the negative impact of widening corporate bonds risk premiums. Further analysis reveals that the widening of the risk premium had a -0.3% impact on the AAA-rated sector and -2% on the BBB sector.
The same analysis by industry sector shows that while the asset backed sector returned 0.3%, the telecommunication & technology and electronic sectors returned -3.7% and -5.3% respectively.
WorldCom's overstated earnings shook equity markets and, as a result, the corporate bond market underperformed as investors sought safer havens in short-dated government debt.
Basic economics suggests investors should seek enhanced returns for moving away from risk-free assets into more risky ones. The specific risk associated with corporate bonds relates to the impact of credit migration (downgrade/upgrade and outright default of the issuer).
The potential capital loss associated with this risk can be estimated by assessing the potential capital loss from credit migrations and multiplying the result by the probability of such an event occurring. This potential capital loss can then be compared to the size of the premium offered to investors to compensate for the risk. It is interesting to note that corporate bonds currently offer more than a fair compensation for the risk.
Can we expect a lower probability of default and downgrades from the current economic indicators in the UK? Despite volatile retail sales numbers and uninspiring GDP, the CBI industrial trends survey provides some confidence concerning the prospects for a broader economic recovery. Furthermore, low unemployment numbers and stable wage levels have been supportive for both consumer and producer.
The market firmly discounted higher interest rates at the beginning of 2002 but a combination of geopolitical tensions and weak equity markets reined in these expectations considerably.
Recent economic data has shown growth becoming more balanced, with the traded goods sector recovering from the depressed levels seen at the turn of the year while domestic demand tempered somewhat.
Our view is that corporate profits will improve over coming quarters and we remain positive on corporate bonds, particularly in the lower quality A and BBB-rated credits.
However, as equity market volatility and weaker economic data in the US continues to generate considerable uncertainties and poor investor sentiment globally, we expect the UK corporate bond market to remain volatile in the short term.
This volatility should not dissuade investors from considering the fundamental value offered by corporate bonds, especially lower grade issues, as the outlook for the economy improves.
Credit quality improves with economic growth.
FRS17 drives pension money into bonds.
Low gilt yields mean low-grade credit.
Equity falls trigger flight to quality.
Defaults wipe out risk premium reward.
Gilt yield rise as a result of higher inflation.
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