Moreover, despite the possibility of some weakening in the fundamental credit environment in 2007, conditions seem fairly benign. But the returns are still out there and investors need to look in all corners.
Interest rate trends in major markets present the first challenge. Most, save the US, are rising, which means investors should consider the effects on duration and the price of bonds, which tend to fall in such an environment.
There was a dramatic upward shift in market expectations for UK interest rates following the surprise interest rate increase to 5.25 per cent in January. The focus of the monetary policy committee remains firmly on the strength of shortterm economic data and its current view is that inflation risk is heightened. The futures market indicates expectations of either one or two more rate rises by mid-2007.
In Europe, base rates were raised to 3.5 per cent last December and 3.75 per cent in March 2007 and the market is pricing up to one more increase to 4 per cent by mid-2007 to combat inflationary pressures.
These expectations should be broadly met although we believe that there remain risks of upside surprises on growth and higher wage settlements which would prompt the European Central Bank to tighten policy more aggressively.
Interest rates in the US have remained on hold at 5.25 per cent since June 2006 and the market’s expectations of multiple interest rate cuts for 2007 have been scaled back against a stronger economic backdrop. That said, the market still expects one cut by the end of the year.
The Bank of Japan raised rates to 0.5 per cent in February. Recent Japanese economic data has disappointed the market and, with the potential for further unsatisfactory economic data, the likelihood of inflation dipping into negative territory and the upcoming elections, the BoJ may find it difficult to justify raising rates as fast as the market expects (three more 0.25 per cent rises are expected by the end of 2008).
For investors in non-Government debt, the economic environment across Europe has been strong for three years and, broadly speaking, corporate balance sheets and cashflows are very healthy. These solid credit fundamentals have led to very low default rates for corporate bonds.
The outlook for non-government debt is well supported on several fronts:
– The macroeconomic environment is benign.
– The corporate backdrop is healthy.
– Equity valuations are well supported.
– There is strong demand for credit.
More than one of these pillars would need to be removed for credit to be seriously affected in 2007.
However, there is the possibility that isolated pockets of weakness could adversely influence individual issuers, which would mean rising default rates in late 2007 or early 2008, albeit only on a moderate basis.
Much of the positive business environment seems to be discounted by tight corporate spreads, making it difficult to see how fundamentals can improve enough to generate attractive capital returns on their own over the medium term. However, the higher yields on credit compared with government bonds are still attractive as investors remain hungry for premium yields in a generally low-yield environment.
The outlook for credit is therefore broadly positive – provided investors mitigate against idiosyncratic or event risk such as M&A activity.
Andy Howse is investment director for fixed income at Fidelity International.