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On guard

Let’s consider the global economic problem in a few statements – low interest rates, lax regulatory control and a proliferation of financial engineering (once referred to as innovation) in the banking industry. Add these together and they have all allowed people and governments to borrow beyond their capacity and for the financial sector to be overvalued relative to loan exposures.

Last year saw the mechanism of the banking sector fail and the public have had front-row seats to a drama created by the destructive power of diminishing confidence. Before last summer, few people outside the Square Mile had linked mistrust between banks to the failure of small businesses in Coventry or Bristol. Now they know only too well.

To help address the fundamental failure of banks, the Government has responded by “guaranteeing” banks’ debt and offering partial nationalisation, all in an attempt to help strengthen their ability to lend again.

There has also been a plethora of initiatives to create growth via large-scale capital projects as well as a mix of timid redistributive taxation plans and direct industrial grants. But all have had limited impact and the slide of the UK into recession has been the inevitable result.

The sharpness of the downturn and the speed of the decline have taken all but a few by surprise. Given the level of indebtedness in the UK, it has compared badly against European, US and Asian countries. The most immediate and obvious expression of this is currency devaluation as overseas investors move their cash to other shores.

For the corporate treasurer, all these factors have led to a reduction in the number of lenders as well as a reduction in margins from sales. As financing costs have risen, corporate spreads have widened to all-time highs. For example, in 2003, Ford Motor Company five-year maturity debt was issued at 6 per cent while similar paper with good covenants was issued at 13 per cent in 2008.

Until 2008, it was acceptable to find a way of placating the investor through financial wizardry. Net sales for most of corporate Britain had not improved over 10 years but financial engineering and better funding terms (for example, lower interest rates) had enhanced balance sheets and kept Wall Street expectations assuaged.

It is true that default rates are expected to rise during 2009 but the market is overshooting even Moodys’ expectations of a rise from 2.8 per cent to10.4 per cent for sub-investment-grade bonds.

For higher-rated bonds, expectations are not so stark, but the yield offered is still providing a significant premium for the potential risk.

For the UK-based fixed-income investor, these macroeconomic ruminations have led to a confusing number of signals to consider.

In essence, the key to successful bond investments will be how well we are able to navigate between deflation and inflation over the medium term. Conventional bonds do not perform well under inflationary conditions.

Spreads have widened to very attractive levels for investment-grade corporate bonds and, at present, the concern regarding inflation has some time to manifest itself. In the meantime, the risk of default of these assets is being compensated adequately. Other aspects of bond investments also provide comfort for the investor. A coupon on a corporate bond is a contractual obligation and so differs from equities where dividends may vary depending on earnings.

It is also important to remember that corporate bonds are placed higher in the capital structure of a company and so experience a higher recovery rate on the assets if the company does go bankrupt.

Names with excessive indebtedness or overly exposed to recessionary factors may be avoided. On the upside, Government subsidy for certain industries can provide a welcome “bond floor” and those industries with a captive franchise will also be attractive.

UK Government bonds with an average maturity of five to seven years are at the greatest danger from inflation. Increased issuance and the widening of perceived risk will make these investments a less viable proposition.

The UK Government expects to issue £135bn of debt a year over the next five years. This will be conducted by the Debt Management Office. Only four UK bond auctions have failed since they began managing issuance of debt in the 1980s. Before the failure in March, the most recent was in September 2002.

We should note that a German bond auction failed at the start of the year as worries grew over the vast amount of bond supply. The chance of another bond auction failing has risen and this will put added pressure on pricing.

Further into the future, as the burden of heavy indebtedness and increased money supply start to unravel, we may see a sharp reversal back to inflationary pressures. In this case, index-linked bonds may well be the asset class of choice, providing a welcome haven from the corrosive damage caused by higher inflation.

Deflationary pressure similar to that seen during the 1930s in America and during the 1990s in Japan may still be a heightened fear but we may find that policy responses to reflate the economy trigger inflation quicker than the market is currently expecting.

The key message for all fixed-income investors is to keep vigilant and be prepared for more volatility during this year.

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