Bond yields are likely to rise, but should be capped by institutional demand and a more disappointin...
Bond yields are likely to rise, but should be capped by institutional demand and a more disappointing outlook for 2005.
We would therefore suggest that, on a longer-term view, a portfolio of higher-rated corporate bonds will offer solid returns, particularly if measured on a risk-adjusted basis.
Overall, bond yields look too low against our fundamental model, which suggests 10-year yields should be closer to 5.25%.
We also expect the recent disinversion of the yield curve to cease as overall yields rise, while there is a risk demand for longer-dated assets will increase as investors switch out of equities or lower-rated corporate bonds.
Government bond yields have fallen sharply over the summer and yields on corporate bonds have fallen even faster. Spreads on these relative to government bonds have almost fallen back to 1995 levels.
Valuations look stretched after the recent rally because of the housing data, and the markets are at risk from stronger economic data.
Ally this to the fact we believe interest rate expectations are too optimistic - retail sales data and underlying price pressures suggest base rates have yet to peak - although this view may be questioned in the light of recent industrial production data.
We wait to see whether the recent fall in government bond yields triggers a host of two- and three-year fixed rate mortgages, potentially giving a boost to the market at a time when comments from Monetary Policy Committee (MPC) members aid sentiment.
There is also encouragement in the fact mortgage approvals are still consistent, with house price inflation at more than 10%. With the fall in five-year bond yields, it will be interesting to see if lower fixed rate deals prompt even more mortgage refinancing, which could further boost consumer spending.
We believe the FSA's capital requirement proposals could still have a big impact on corporate bonds. The market continues to speculate about whether life companies will radically alter their asset allocation policies as a result, possibly by switching out of corporate bonds into equities and gilts.
The new rules were seen as slightly positive for higher-rated credit compared with the previous proposals. AA and AAA-rated bonds have come out best, with longer dated, lower-rated credit the most vulnerable.
Perversely, lower-rated credit has rallied as investment banks have repackaged lower-rated deals into vehicles with a AAA rating, which has prompted a squeeze at the lower end of the investment grade market.
But we fear further upside may be capped as positive cashflow will be increasingly directed towards the equity market in the form of higher dividends. The risks from M&A, LBOs and MBOs have also risen.
Shorter term, UK growth forecasts have been revised higher for 2004 to 3.3%, but 2005 forecasts have been revised down to 2.6%. Headline inflation remains low, but there are worrying signs that inflationary pressures are building.
In particular, the longer the oil price remains high, the more wage pressures may begin to build, particularly given the economy is at full employment. Any wage inflation would hit bonds badly.
Institutional demand for bonds.
UK bonds look cheap.
CPI below state target.
Gilt yields too low.
Corporate spreads tight.
Interest rate expectations too optimistic.