The Budget was not the most exciting we have seen but, for the trustees and investment managers of company pension schemes, it heralded a number of important changes to funding requirements.
So what, you might think, and you would be forgiven for hardly batting an eyelid at news of the Government's decision to back the recommendations of the Myners report. However, you would be wrong to dismiss this announcement as irrelevant as its repercussions affect the markets and investors. The recommendation is an important development and a very big plus for corporate bonds.
Confirmation that the minimum funding requirement for pension funds is to be abolished was not entirely unexpected. For several years now, the MFR has exerted an influence over the long end of the gilt market – those gilts that mature in 15 years or more. This is because its basis for assessing liabilities has encouraged many pension funds to adjust their asset allocation away from equities and in favour of long-dated gilts.
The impact this increased demand has had on the gilt market has been exacerbated by the dramatic fall in gilt supply that is an ongoing trend. Demand for long-dated gilts from life funds has also been high as they seek to cover their guaranteed annuity exposure. Inevitably, this has resulted in the yields of long-dated gilts being pushed down as prices have moved up.
Some might consider the decision to abolish the MFR encourages pension funds to adjust their asset allocation in favour of equities. Taken in isolation, it could certainly be viewed that way. But the positive impact it has been having and will continue to have on corporate bond markets is worth considering.
First, if the MFR is abolished, some of the premium that exists in long-dated bonds should certainly start to unwind as greater flexibility becomes possible within the fixed-interest holdings of pension funds. While there has already been some evidence of this occurring, it is unlikely to unwind completely in the medium term. Even so, corporate bonds should benefit relative to gilts.
Second, as you might expect, the anticipation of MFR going has been fuelling demand for UK corporate bonds for some months. But also of relevance to UK bond markets is the implementation of accounting standard FRS17. This requires companies to discount their pension liabilities using the yield on AA-rated corporate bonds and show any pension fund deficit or surplus each year in corporate accounts.
Although FRS17 will not fully come into play until accounting periods ending on or after June 2003, the markets believe it will magnify the pressure on pension funds to increase bond weightings. This will act as a restraint on pension funds which might otherwise consider using their new-found flexibility to move money out of bonds into equities. So, it too favours corporate bonds over gilts.
All these factors combined have meant that, for the past six months, UK corporate bonds have outperformed gilts and overall demand from investors has proved almost insatiable. Our outlook for corporate bonds for the remainder of 2001 is also positive.
To date, the biggest beneficiaries of the anticipated abolition of MFR and the economic/market environment have been the more traditional investment-grade corporate bonds. These offer greater capital security but lower yield than high-yield bonds and are particularly attractive given the background of slowing global growth, nerves surrounding technology bonds and cautious investor sentiment.
Thus, many bond funds have been persuaded to increase their exposure to investment-grade corporate bonds, pushing up their price.
However, with the exception of a few sectors, high-yield corporate bonds have still performed well, particularly since the start of 2001, and the outlook for them is improving all the time.
Looking ahead, we believe the current economic gloom will give way to recovery in the second half of the year. Then, as earnings growth becomes less of a concern as the year progresses, the perceived risk of corporate bonds at the high-yield end of the market will diminish and they will become increasingly attractive. Even so, sector and stock selection within the corporate bond market will still be key.
Furthermore, if the recovery that we anticipate is delayed, then corporate bonds remain attractive relative to equities. As defensive tools, they will still provide a strong income stream and investment-grade corporate bonds certainly have less risk of capital erosion than equities.
In terms of bond returns, over the coming 12 months, we expect the bulk of these to come from income, with some marginal capital appreciation on top. For investors, this means double-digit returns could be achieved by bond funds that invest in investment-grade or higher-yield corporate bonds. Given the greater yield and continued scope for recovery in prices, however, we believe the high-yield sector may marginally outperform its investment-grade counterpart although this should be viewed in context of potentially greater volatility in returns.
Although the MFR is to be abolished, the timing of its withdrawal remains uncertain. The introduction of the Myners framework requires primary legislation, as confirmed by the Treasury/DSS proposal, so implementation could be at least a year away. In the interim, we can only assume that the MFR remains in force in its current form.
This means some of the demand for long-dated bonds will stay in place, tempering any underperformance that might otherwise have resulted. It does not, however, diminish the growing demand for corporate bonds or the positive outlook for bond funds.