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Zeroing out of 2000

This is turning out to be another difficult year for bond investors. In the Government markets, we have been faced with inverted yield curves, tough competition from rising interest rates on cash and a miserable trickle of new stock supply.

There has been nothing to arouse the interest, let alone the excitement, of individual investors or asset allocators. Altogether, it would appear the sooner the year is over and the underperformance relative to cash slips away into historic record, the better for all concerned.

On the corporate credit side, circumstances have likewise been less than supportive. Shareholders are generally happy to see increased gearing on company accounts, making up for the shortage of Government supply with a heavy flow, sometimes amounting to a flood, of new issues.

In the market background, economic and financial events have also proved almost entirely negative. The financing for third-generation mobile telecommunications, the cost of replacing obsolete technologies, the oil price increase and even the widespread political protests all have negative connotations for corporate cashflows and credit-worthiness.

In the UK, even the expected salvation of the market – the actuaries&#39 recommendation to reform minimum funding requirement, a test on a pension fund to check its ability to provide for its members, by increasing their exposure to corporate bonds – has turned out to be a damp squib.

The report was viewed as more of a discussion document, with the Myner&#39s Report, an interim report expected with the Chancellor&#39s autumn statement, becoming more significant. Current expectations are that the report will be more far-reaching by encouraging inc reased investment in venture capital. Overall, it appears that any changes in pension fund regulations could be years rather than months away.

Yet, despite the unrelieved gloom, there have been pockets of good performance. The high-yield indices have outperformed their investment grade counterparts. In the financial sector, subordinated debt is starting to perform better and recent telecoms issues, correctly priced, have delivered respectable returns.

After two years of bad news and poor performance, might bond investors&#39 patience be about to pay off? Are there discernible changes in the market background which point to a genuine improvement in prospective returns?

First, we need to look at valuations. Government bonds are clearly not cheap but the same does not hold for corporates. The general market in corporate bonds was repriced by the BT credit rating downgrade. This was widely expected but the possibility of the rating going to BBB was not. This highlighted the additional costs that BT and other telecoms companies would incur in funding the 3G licenses.

However, post-sell-off, corporate bonds are now exceptional value to investors. Telecoms companies may not be the ideal area to invest but property companies are offering 10and 20-year bonds with yields of 7-7.5 per cent. In the banking sector, tier one highly subordinated debt issued by some of the high-street banks has yields of 7.5 per cent and slightly higher.

Second, the economic background remains disinflationary. Generally, this would be positive for bonds. However, much of the good news is priced in. So, when events such as a jump in the oil price and unexpected higher costs of mobile phone licences occur, they can act as a short-term shock to bond yields.

The major concern is that the inflation genie has escaped out of the bottle. These shocks tend to be short term by nature and bonds will recover, especially with the world&#39s central banks targeting low inflation. Oddly, it is the world economy that is not growing fast enough to re-establish pricing power for distributors or suppliers which should concern corporate borrowers.

The ability to service a fixed coupon becomes increasingly difficult with no pricing power. The deflationary environment does mean that corporate bonds need to be selected carefully. Pricing power is a key factor.

This would generally put bonds issued by industrial names such as Corus out of favour and possibly certain retailers where margins continue to be squeezed. Pharmaceutical companies and, to some extent, oil companies would be better investments as they are less constrained.

Third, the balance of supply and demand for bonds, while arguably unsupportive, is at least fully discounted at current yield spreads. In the UK and US, we are arguably very close to the top of the interest rate cycle. Disinverting yield curves improve the attractions of bonds relative to cash. The supply of new corporate stock is heavily discounted in the market and it is difficult to see how this factor
can produce any further repricing shocks.

The telecoms issuance has been heavily signposted to the market so any reduction in the amount of debt to be issued, asset disposals or even the raising of more share capital by telecoms companies, will act as a positive driver to the corporate bond market.

Supply could further dry up if the euromarket is more attractive for issuers. Many issuers have chosen the euro market in preference to sterling as the deal sizes have been bigger and there have been fewer restrictions on the borrower.

At this juncture, it might only take small shifts on the demand side of the equation to move markets a long way. On the institutional side, there is continually talk of changing benchmarks. The decline in gilt issuance results in many investors buying already overvalued Government debt, as it is “part of the index”. This in turn makes the bonds more and more expensive.

This circular argument could quite easily be changed by using various composite indices with the weighting in Government and corporate debt proportional to the amount of bonds available. On the retail side, falling cash rates will push investors into higher-yield assets, with corporate bonds high on the list. These small changes in demand will lead to improved performance for corporate bonds.

This year seems set to be one of low absolute returns for bond investors. Much of the bad news has occurred on oil prices, telecoms licensing costs and the uncertainties over pension fund legislation. But the environment is looking more positive for bonds and corporate bonds especially.

On a relative value basis, Government bonds appear expensive against corporate bonds. The possibility of BT being downgraded to BBB has been countered by BT claiming they want to maintain an A rating. The asset allocators are beginning to favour corporate bonds and this can quickly tip the supply/demand balance forcing prices higher. Patience is starting to pay off – careful selection of corporate bonds will offer increased returns with generous yields.


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