The past few months have presented tough challenges for investors. The underlying sensitivity of the...
The past few months have presented tough challenges for investors. The underlying sensitivity of the market means that bad news - rumoured or otherwise - is punished, and liquidity can still evaporate very quickly. Trading in this kind of environment can be difficult, and we have already seen evidence of credit issues persisting into 2008.
At this juncture, the market is anticipating significant writedowns from Wall Street. This situation looks unlikely to ease until the second quarter of 2008, when we would hope for greater clarity surrounding financials. Liquidity is also back to August levels, and the flight to quality has resumed.
The Bank of England kept UK rates at 5.50% in January, with concerns of higher inflation outweighing fears of weaker growth. Keeping rates higher while the economy slows can negatively impact corporate balance sheets and increase the likelihood of defaults. Gilt markets are now pricing in the possibility of at least four cuts of 25 basis points by the end of 2008. In the US, the ultimate impact of the sub-prime crisis remains a huge unknown. A recession in the US is most likely, and the Federal Reserve is ready to act[as shown by the 0.75% rate cut on 22 January, after this piece was written].
Both financials and non-financials continue to find it difficult to harness funding in the wholesale commercial paper market. Therefore, in 2008, companies are likely to seek this out in corporate bond markets.
With more defaults likely, the pressure on earnings and a supply glut, primary issuance will have to be discounted, and this is likely to lead to repricing in secondary markets in the first half of 2008.
Furthermore, we expect less demand for structured products following the credit squeeze in 2007. This will further accentuate the widening of spreads.
Such times, however, are not without opportunity, and high-quality, defensive debt, backed by strong balance sheets, limited M&A risk and conservative financing structures should benefit investors now. Indeed, they would do best to wait until the second quarter before looking at riskier strategies.
- Trading in the current environment can be difficult;
- Corporate bond issuance is likely to rise as companies find it harder to secure commercial funding;
- Slackening demand for structured products will accentuate the widening of spreads;
- Bryn Jones, investment manager, Rathbone Ethical Bond fund.
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