Careful what you wish for, my mum said when I was a child. Admittedly, she was never talking about bond managers wishing for market volatility but it is still useful cautionary advice.
Over July, credit spreads – the extra yield over gilts required by corporate bond investors – have increased significantly. This has affected all areas of the corporate bond market to some degree.
This would have made corporate bonds fall in value. However, in July, gilt yields fell significantly, pushing the price of gilts and corporate bonds upwards.
Corporate bonds have risen in value over the month for the first time this year but bond managers would have been far better off being invested in gilts.
Bond market volatility is now well and truly with us and the equity market has decided to join in.
So why has this occurred and what happens next?
The movement in the credit market has been primarily caused by fear. First, problems in the US sub-prime mortgage market are continuing. Rising interest rates have made mortgage payments more expensive. Also falling house prices, many sub-prime borrowers now have negative equity on their houses.
So mortgage defaults have started to rise – why pay more if your house is worth less, especially if you have a poor credit history?
In the US, there is a big market of bonds supported by cashflows from sub-prime mortgage lending. There are concerns that bonds backed by these mortgages will default and these losses will affect other areas of the bond markets. For example, it is not clear how banks’ profits and balance sheets will be affected and it may take some time for this to be known.
Second, investors’ appetite for credit risks is starting to reduce. There is a large pipeline of bonds and loans, particularly in the US, due to be issued. Reports indicate investors are demanding higher yields and stronger investor protection clauses before they agree to provide the capital.
A deal for Alliance Boots hit the headlines after the private equity firm KKR failed to raise the finance it needed for the transaction. Some of the finance was raised but at a much higher price than previous comparable deals. The rest of the debt used in the deal was retained by the investment banks reducing their capacity to fund other deals.
There is a limit to how much debt banks will be happy to retain and how high a price companies will pay to raise capital. So we could see less bonds being issued until investor confidence returns.
Much of the recent equity boom has been fed by acquisitions. Share buybacks have also been common. These have been financed by the cheap bond markets. If that tap of money is closed off, these sources of market return could disappear, too.
So that is why the equity markets have started to follow in the footsteps of weaker corporate bond markets.
Finally, the equity and corporate bond concerns have caused a “flight to quality” which incorporates a flight to gilts, pushing down gilt yields. Hence, gilts go up in price, bringing up the price of corporate bonds.
So what happens next? As I said earlier, the credit problems appears to be driven by fear. Economic growth remains stable across the globe and bond defaults remain low. This suggests markets have overreacted and will recover in due course. So there is no point selling at current levels and it might be worth buying?
It’s possible that the banking sector struggles due to less income from corporate deals and loans sitting on their balance sheets getting into difficulty. Taking this further, corporate growth could suffer as companies struggle to finance business development. Taking that to the extreme, we could be on the verge of a global recession, just as the credit markets indicate, in which case sell now if you have not already.
What are we doing? We are holding onto our corporate bonds and assessing when to buy more. But we are also keeping an eye on the banks and corporate activity.
Kevin Telfer is fixed-income product specialist at Aegon Asset Management