BEN LORD, manager of the M&G High Interest fund on Bonds
We were reasonably bullish on fixed income coming into 2010. But did we expect by the middle of August gilts would have returned 6.5% and sterling corporates would have returned 9.2%? Absolutely not.
Before this crisis in 2006 and early 2007 you could put your cash on a guaranteed deposit paying you more than 5%, and this was yielding more than an investment in sterling investment grade credit. Today, deposit yields are negligible, while sterling investment grade credit yields approximately 5%. So the reverse is true, and the asset class looks attractive.
Clearly, the concern is either gilt yields rise or credit spreads widen, which creates a capital loss on your fixed income investment. So how are your potential returns affected by these scenarios?
If you are concerned gilt yields are too low and you expect a 1% parallel rise, you will lose around 7% of value, but your total loss is only 2% because of the cushioning effect of income. Perhaps you are more bearish and you also think credit spreads will widen 100bps? In this case, you lose 14% capital, but your 5% income limits your downside to a 9% loss over the year.
But that is not our core scenario. The US has led the UK and Europe throughout this cycle: it was first to experience negative growth and first out of recession, its property prices were first to fall, and unemployment was first to rise. And you can find few better forecasting tools for gilt yields than the US treasury market. Recent economic data in the US has been nothing short of shocking: almost every indicator has come in well below expectations, prompting speculation about a double-dip recession, about deflation, about the Japan scenario, and about a second bout of QE.
All of these things would be positive for risk-free yields, and if the recent relationship between the US and UK persists, gilt yields could reach new lows.
So, what are our expectations going through to year end? Given the sharp downward turn of recent data, gilts can continue their strength. And given our view of the improvements in corporate fundamentals and expected low issuance, we also believe credit can continue to tighten.
Given the crisis we have just come through, the reverberations will be felt for years. Sovereign risk will periodically rear its ugly head, and banks will continue to be volatile. Both of these things will lead to volatile investment markets. Nonetheless, the more likely scenario than a 9% adverse case is for further strength in gilts and further rallying in credit into the end of 2010.
Ben Lord is manager of the M&G High Interest fund
