By Anna Lees-Jones, manager of the M&G Corporate Bond Fund In today's turbulent financial market...
By Anna Lees-Jones, manager of the M&G Corporate Bond Fund
In today's turbulent financial markets, any asset class that can be relied on to produce a steady return deserves to be highly prized.
Investment grade corporate bonds, like gilts, have continued to fulfil this role during the first half of 2002, although they have attracted much less attention than last autumn when pension fund switching from equities into bonds was briefly headline news.
Institutional demand for good quality corporate bonds remains strong. Indeed, demand exceeds supply in some areas, especially for highly rated bonds, such as AAA to A-rated issues.
There has been a steady stream of new issues this year, but the most attractive are heavily oversubscribed. Despite the increasing size of the corporate bond market, liquidity is generally better in gilts. The issue of pension fund switching away from a heavy weighting in equities (still as high as 70-80% in most cases) remains live, with consultants suggesting that, though it depends on each fund's specifics, typically a weighting of 60% or below would better match their obligations and risk tolerance.
In recent months, there has also been much discussion of insurance companies following the same course of action. Any further weakness in equities would certainly generate news stories along these lines.
Gilts and investment grade corporate bonds are benefiting from their status as defensive assets and the more favourable interest rate outlook. UK inflation has slipped below 2% and potential pressures from booming house prices and rising consumer debt are being countered by deflationary influences elsewhere.
There seems a good chance that the Bank of England will only raise base rates modestly, perhaps by 0.25% or 0.5% by the year-end.
The market is still pricing in somewhat higher rates. If gilts look quite attractive (for example 10-year stocks still yield 5%), then the spreads offered by investment grade corporate bonds, 100 basis points for A-rated issues and around 160 for BBB rated stocks, appear even more enticing.
For retail investors, low interest rates mean modest returns from cash deposit accounts.
Corporate bond funds investing in investment grade issues and gilts currently yield well above 5%, with a relatively low risk profile. Of course, investors have become much more aware of risk in recent months. With companies facing no let-up in business pressures, the proportion of downgrades to upgrades by the credit rating agencies has risen steadily.
A number of high profile companies, for example, Invensys, Tyco and Worldcom, have seen their debt downgraded to sub-investment status (below BBB). These fallen angels now form a significant proportion of the stock universe of high yield bond funds.
Investment grade corporate bonds may be overshadowed by equities if there is a general recovery in the stock market, but there is good reason to suggest that long-term returns will rival those from equities and that the risk profile is lower.
Good inflation and interest rate prospects.
Steady assets now have an added appeal.
Strong demand for corporate bonds.
Need for diligence against downgrades.
Need for further diversification.
Less liquidity in lower-rated bonds.