To paraphrase Tammy Wynette, sometimes it’s hard to be an investor – no more so than in bond markets during the 18 months up to last December. For those who believe economic factors ultimately determine interest rates, it has been difficult and demoralising to witness the relentless decline in yields, particularly at the longer end of the UK government bond curve.
Such a sharp reduction is usually a harbinger of recession, yet yields fell despite rising inflation, improving economic growth, rising consumption, mounting consumer indebtedness and deteriorating fiscal and monetary conditions. For many months, it has seemed the only positive reason to buy gilts has been the preponderance of buyers over sellers. As Tammy might say, sometimes markets do things “you jes’ don’ unnerstan’.”
In the UK, the obvious culprits of “The Great Gilt Misvaluation” have been pension and life companies forced by regulators, accountants and actuaries to match long-term liabilities with “safe” assets such as gilts, regardless of the price. This has led to a bizarre situation. As gilts have risen in price so has the cost of funding outstanding liabilities, which are derived from gilt prices. And the higher the cost of these liabilities, the greater has been the need to buy greater volumes of increasingly expensive government bonds.
The correction in government bonds since January has been welcomed by institutional investors. Once the pension-and-life company vicious circle broke, it was clear bond prices could plummet: following the liability-matching investment principle, the higher the yields the lower the liabilities, reducing the need to buy interest-bearing instruments.
Surprisingly, the sell-off affected shorter-dated as well as longer-dated bonds as investors recognised that the Bank of England might lift base rates. Although the shape of the UK yield curve still has some way to adjust – it is likely to steepen at the longer end – sanity has begun to return in maturities of less than 10 years.
Although short-term gilts now offer good value, many commentators have concerns about corporate bonds. Most retail investors access fixed interest securities through corporate bond funds and both investment and sub-investment grade securities now trade on historically low yield premiums to their government counterparts. Are corporate bonds heading for a nasty correction?
Corporate bonds carry two main credit risks. The most common for high-quality issuers is “event” risk – the possibility that corporate activity will damage a company’s credit rating. Event risk rises when takeover activity is high, as in recent months. In addition, potential credit problems have begun to emerge with the increased borrowing by some companies. So, although top-quality bonds have held quite firm, they are increasingly vulnerable to event risk. This could lead to underperformance and New Star’s managers have restricted their holdings accordingly.
Then there is default risk. Default is rare for investment grade bonds but more prevalent in the high-yield arena. Typically, defaults wane when economies grow and rise during slowdowns. Currently, with US and UK growth reasonably healthy and the eurozone reviving, global default rates are at a nine-year low.
European default rates are now almost zero and a significant short-term rise is unlikely for various reasons. First, fewer CCC-rated bonds have been issued in Europe recently than in the US. Secondly, the vulnerable sectors, automobiles and airlines, are less prevalent in Europe.
Thirdly, “survivorship bias” exists among European high-yield borrowers. Companies that survived the 2000-02 default cycle tend to be higher quality than those in the US high-yield pool, with better quality revenues and more stable cash flows. Fourthly, after the 2000–2002 collapse, investors discouraged companies from doing new issues and European covenants were improved, making the market stronger. Finally, most companies have high cash levels in their balance sheets.
How should investors react to this situation? Caution remains appropriate concerning long-dated gilts. Real yields are low and gilt issues are increasing. Base rates, meanwhile, are likely to remain relatively stable over the next year so the shorter-dated gilts look good value.
Investment grade corporate bonds still look precarious, with spreads tight and event risk on the rise. High yield bonds, however, appear attractive. The economic fundamentals continue to suggest that weaker companies should flourish and their creditworthiness should improve. Default risk remains low and is unlikely to rise as fast as pessimists suggest while supply is low and dwindling.
Investors faced bad times in bonds recently and the volatility in gilts in particular may continue. Investors who watch their duration and cultivate the higher-yielding end of the credit spectrum, however, should make healthy returns. Bond markets are now comprehensible and offer value.
New Star Asset Managers Limited is represented in Malta by Jesmond Mizzi Financial Services Limited. Theo manages the New Star Strategic Government Bond Fun, which is promoted in Malta in terms of the UCITS Directive.