While last year will be remembered as a miserable year for equity markets, bonds provided some relie...
While last year will be remembered as a miserable year for equity markets, bonds provided some relief as investors took shelter from volatility and earnings downgrades, particularly in the technology sectors, and parked their money in more defensive asset classes.
In a year when government bond markets performed well against a background of slower global economic growth, corporate bonds tended to underperform government issues, reflecting fears of a US recession and sensitivity to equity market movements.
In the UK, however, the picture was somewhat different. Sterling-denominated investment grade bonds (bonds from issuers with a triple B credit rating or above as determined by credit agencies such as Standard & Poor's and Moody's) were the star performers of the year. They produced a total return of 10.2% in comparison with a return of 8.9% for gilts a direct contrast to the underperformance of other credit markets.
A number of factors contributed to the strong performance of sterling investment grade debt. Unlike the US economy, the UK has not experienced a sharp slowdown. Early last year, the Bank of England's Monetary Policy Committee (MPC) increased base rates to 6% as economic growth accelerated, fuelled by a buoyant services sector and the continuing strength of the housing market.
While economic growth has since slowed, the latest figures for the fourth quarter indicate year on year growth of 2.4%, compared with a previous figure of 3%, in line with the long-term trend of 22.5%. Moreover, higher interest rates and strong competitive pressures in the high street have meant inflation has remained generally subdued. And the core inflation rate has stayed below the Bank of England's official target of 2.5% for 21 consecutive months.
This has provided a benign investment background for sterling bond markets, with gilt prices rising (and yields falling) across all maturities during last year. The yield on the benchmark 10-year gilt has fallen from 5.41% to 4.91%.
In addition, UK pension funds have been steadily increasing their exposure to bonds in recent years, and over the last year in particular there has been a growing emphasis on corporate bonds as opposed to gilts. Allied to this, UK insurance companies have been buying long-dated bonds (a combination of gilts and investment grade debt) to match outstanding liabilities. This has been accentuated by merger and acquisition activity in the sector, for example, Lloyds Bank's purchase of mutual life assurer Scottish Widows.
These factors have coincided in recent years with the emergence of a budget surplus as government revenues have exceeded expenditure, meaning repurchases of gilts have outpaced new issuance and shrunk the market as a result. This fall in supply, coupled with the increase in demand from institutional investors, has meant that gilt prices have risen significantly, driving yields on long-dated gilts down to historic lows.
As a result, investors have looked to the sterling-denominated corporate market to fill the gap and obtain a higher income than is currently available from gilts. Due to concerns about the risk of default, buying interest focused on investment grade issues, often from supranational bodies such as the European Investment Bank, and those with a triple A credit rating, the highest rating possible. To give an example of the volume of money involved, in the second quarter of 2000 UK pension funds and insurance companies invested £5.9bn of new money in sterling-denominated corporate bonds.
While investment grade bonds put in an outstanding performance, driven by the volume of new money flowing into triple A rated issues, lower down the credit scale high yield bonds (issuers with a lower credit rating than triple B) had a much more difficult time in 2000.
The high yield market in the UK and Europe is still relatively small compared with the investment grade market and takes its cue from developments in the US, where the market for high yield debt is more developed.
Another point to note is that high yield bonds as an asset class are closely linked to the performance of equities. While not in themselves as volatile as equities, they will nevertheless dip as equities rise and fall. So the malaise that gripped the US and the UK equity markets last year after their peak in March 2000 had a knock-on effect on high yield bonds, as investors became increasing wary of the asset class. As a result, European high yield bonds fell by 11% over the year in total return terms. The sector rotation within the US and European equity markets was also mirrored in the high yield debt market with a huge variation in returns. In the US, for example, high yield telecoms bonds fell 15% last year, while high yield technology bonds plummeted 16.4%. However, the more defensive high yield sectors performed well, with healthcare bonds gaining 7.2% and electric utilities advancing 12.6%.
This divergence in performance was related to the credit crunch in the US, which impacted globally on the high yield market. US lenders, particularly investment and regional banks, became wary of lending capital to high yield borrowers.
Corporate earnings downgrades, particularly in the technology and telecoms sectors, volatile equity markets and the potential for an economic 'hard landing' have all conspired to have a chastening effect on potential lenders, making them more risk-averse and reluctant to finance businesses perceived as higher risk.
As a result, the yield gap between high yield bonds and US Treasuries (a barometer of the relative valuation of high yield bonds) rose to 894 basis points at the end of 2000, the highest it has been since the last recession in 1990. Effectively, the high yield market was pricing in a US recession in 2001.
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