Over the course of the past six months, markets in general and the corporate bond market in particular have been preoccupied with sovereign default risk – in Dubai in December, Greece in January and February and, most recently, in Portugal, Italy, Ireland and Spain in April and May.
At other times, sovereign concerns have been put to one side as the focus has switched to the more positive factors of good company results and improving economic newsflow. This has resulted in a volatile market environment in which liquidity has periodically been limited.
We have responded to this by adding to risk during periods of weakness and reducing risk as the market has recovered. This strategy has served us well this year.
We acknowledge that budget deficit reduction is a process rather than an event and will take time, hence we expect similar market conditions to continue to prevail during the coming months. In the UK the budget deficit is considerable, with the latest official forecast suggesting £160bn. However, this is an improvement on the estimate given by previous Chancellor Alistair Darling of £178bn and earlier expectations among City economists that the true number would be closer to £220bn.
Despite the size of the deficit in the UK, we are not overly pessimistic about the gilt market but neither are we overly bullish.
Although there are plenty of gilts in issue, they are cheap, the yield curve is the steepest in the industrialised world and the term structure is very favourable. The UK has a history of issuing long-dated Government bonds and there is little refinancing risk. Finally, domestic ownership is high and there is limited reliance on overseas investors.
The state of the UK’s finances is such that we anticipate tighter fiscal policy, although monetary policy will need to remain loose to stimulate growth. We have recently seen a rise in inflation, although this is largely attributable to base effects, given the changes to VAT and the sharp moves in fuel prices.
With sterling stabilising, imported inflation is less of an issue. Household consumption will come under pressure from higher taxation and Government spending will also be constrained. Unemployment is also expected to rise, meaning less pressure on wage growth – the biggest component of overall inflation.
The Government will need to strike a balance between acting quickly enough to satisfy the markets and delaying long enough to avoid derailing economic growth.
An environment of stable, if unspectacular, economic growth combined with loose monetary policy should be conducive to further progress for corporate bonds.
Furthermore, issuance remains modest as corporate balance sheets are being repaired faster than anticipated while banks are lending again as corporate activity has increased.
Against this backdrop, we are following a theme of long-term value, focusing on more cheaply valued areas, such as banks and asset-backed securities, rather than more fully valued sectors such as telecoms and utilities. At the same time, we will continue to add value by taking shorter-term tactical decisions – which, with our fund size, we are well placed to be able to do – as we expect positive economic and corporate news to continue to vie with sovereign default fears over the coming months.
Stephen Snowden is manager of the Old Mutual corporate bond fund