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Bonds show stickability

Economic conditions will put pressure on them next year but bonds still offer value if you tread carefully

The bond market has had a tremendously good run of late, to the surprise of many commentators. Three months ago, there was talk of the need to increase interest rates to quell rising inflation despite a slowing economy. A nasty cocktail of stagflation, higher defaults and rising interest rates was feared. For the corporate bond market this may as well be Armageddon.

The response of the central banks to this threat has been fairly sharp. Interest rates in Europe are increasing and a tighter monetary policy has been signalled for next year. In the US, interest rates have been increased at every Federal open market committee meeting this year with no respite expected in December, or early next year. The impact is already being felt – the US economy is slowing and this is expected to take the sting out of recent inflationary pressures.

In practice, the market had got a little overexcited. The most recent inflation statistics have been lower than anticipated. Oil prices are feeding through to input prices, but much of the impact is being absorbed by producers rather than being passed on to consumers. The main fear is of secondary effects, in particular, wage inflation and ultimately more deep-rooted inflationary expectations, but so far there is little evidence of this.

Against this backdrop, the UK market has performed by far the best and Government bond yields have fallen sharply. Part of this is due to the need by pension funds to match their liabilities, resulting in forced purchases of bonds.

Furthermore, the UK has been seen as a relatively safe haven with interest rates being cut in August and some expecting more cuts next year. Increased Government expenditure is not being matched by receipts, leading inevitably to higher taxation. In response to a tighter fiscal policy, monetary policy will be relaxed.

Corporate bond spreads are in a more worrying stage of the cycle. Many investment grade bonds are under threat from private equity. These companies are highly geared with a low rating so a private equity acquisition means your comparatively safe A or BBB-rated bonds suddenly become B-rated and the bond price falls dramatically.

Furthermore, there has been a dramatic increase in more shareholder-friendly moves. Corporate activity is increasing, with many large companies taking over smaller firms. Dividend policy is also becoming more aggressive and special dividends and share buybacks have returned. Returning cash to shareholders is good for my equity colleagues, but a problem for bondholders – especially if these dividend payments are funded from the bond market.

This means that parts of the investment-grade market – particularly the A and BBB areas – are comparatively dangerous territory, but there are still pockets of value. Ironically, some of these perceived private equity takeovers are unlikely to occur because of the large deficits in their pension funds. The new powers granted to the pension regulator, David Norgrove, mean that if a company is taken over by a firm with a materially weaker balance sheet, it may be forced to make good the pension fund. This could be an expensive process, as the assumptions would be based on buying a basket of bonds or annuities. Effectively this poison pill could be too much for private equity groups to swallow, therefore providing value for bond investors.

The high yield area is a major beneficiary of the greater corporate activity. They are the companies which tend to be taken over. However, this is the area where you need to be the most stock specific and there are a number of dangers. Default rates are at record low levels but are set to rise and this may start to unsettle the market, especially if GM goes into Chapter 11 in 2006, which is a distinct possibility. Further, private equity refinances big acquisitions in the debt markets and there are a large number of these due in the early part of 2006. This may well overwhelm the markets providing some good buying opportunities.

There will be a very disparate performance between the best and worst funds in the next 12 months, with a very nimble investment policy necessary as the year develops.


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