The corporate bond waiting game continues

The publication this week of the Bank of England's Money Policy Committee minutes has revealed that the committee was split 5-4 over whether or not to raise UK interest rates with the more hawkish Governor, Mervyn King, voted down.

According to Citywire AAA-rated Fatima Luis, manager of the F&C Strategic Bond Fund, this is a further signal that the end is not yet in sight for the cautious climate facing corporate bonds.

"At the start of the year the market was concerned about a housing led slowdown in the US which would likely have resulted in rate reductions," said Luis, whose Strategic Bond Fund has a brief to invest across the credit spectrum, "but my view is that the major risk has all along been a continued rise in yields due to a strong labour market and inflationary pressures."

"As it turns out, US growth has been pretty stable and unemployment remains low. Both the Fed and the Bank of England remain concerned about inflation and the MPC minutes clearly suggest that it is too soon to call the top of the rate cycle."

Luis points out that there is a wall of liquidity in global capital markets and that, in her view, there is "too much risk taking – which makes corporate bond managers uncomfortable: we're paid to assess the downside" .

"As a consequence of this seemingly insatiable appetite for risk, corporate bond yields remain tight and they haven't risen sufficiently to reflect the risk of rising rates. Investment grade yields in particular do not look especially attractive," she said.

"However, as risk is reassessed, yields will rise."

Luis has currently positioned the Strategic Bond Fund relatively defensively, holding shorter dated stocks within its investment grade component, raising cash levels to 7% of the portfolio and also increasing exposure to Floating Rate Notes. She warns that the leveraged loan market, generally considered to be more secure than the corporate bond market, is starting to display 'bubble-like' characteristics as loan providers are rushing to offer to re-price company loans at ever lower rates, and with weaker covenants, just to stop companies re-financing elsewhere.

"All of this has been accompanied by the easing of loan conditions and a general deterioration in the credit quality of borrowers. This has echoes of some of the developments that preceeded the problems in the sub-prime loan market, the full scale of which has yet to be understood. It is clearly an unfolding story as witnessed this week with the fire sale of sub-prime assets from two Bear Stearns hedge funds" she said.

Luis argues that the trigger point for a turnaround in credit markets will be clear signs that the tough medicine of rate rises is starting to have an impact.

"It is clear from the views at the latest MPC meeting that we are not there yet," she added, "but when the turning point comes investors need to be in a position to respond quickly. For the retail investor that means being in a bond fund with a very flexible remit rather than those narrowly boxed into one part of the fixed income spectrum."