Will bond markets run out of road in 2007?

The bond markets have travelled through 2006 without too many bumps in the road but as 2007 approaches a major slowdown in the US could see default levels jump sharply, warns Ian Robinson, manager of F&C Fixed Interest Fund.

Robinson, who is part of a team managing some £22 billion of corporate bonds, said that the equity market falls in the second quarter of 2006, caused a sell-off in credit particularly at the high yield end of the market. He points out that at this time, credit defaults also appeared in Europe for the first time in over a year.

"We have had a few more defaults during 2006, such Euro Tunnel which was high profile. Nevertheless, defaults numbers for 2006 have remained low with global defaults below 2%.

"Perhaps of more significance to bond markets in 2006 were the increasing levels of leverage both among companies as well as investors.

"Private equity firms have been buying bigger and bigger targets, such as hospital operator HCA in the US, with debt levels continuing to rise. Meanwhile, investment banks, through structured credit products, have been offering investors new ways to increase levels of leverage and thus potential returns.

"Leverage will continue to be a theme in 2007 albeit at even greater levels. Private equity firms have managed to raise billions of dollars at the drop of a hat which now brings larger companies firmly into the frame of private equity investors."

According to Robinson, investors are still yield hungry with bond yields around the world at very low levels from a historical perspective.

"Investors continue to seek the Holy Grail of structured credit products that offer the biggest return for seemingly little risk. For bond fund managers trying to generate alpha, the going will remain tough. But there will be opportunities.

"Issuance will continue at a breakneck pace. This will include investment grade and high yield issuance from companies, many of them new to the market, as well as hybrid products such as subordinated bonds. The latter can offer investors higher yield but places them second in the queue should the company run into difficulties."

Although Robinson believes a soft landing is the most likely outcome for the US economy, the major risk for 2007 remains the unpredictability of quite how soft that landing will be and how it could impact growth in the rest of the world.

"In the worst case scenario of a US recession, the ability of companies to borrow will decline, thereby forcing them to pay a significantly higher yield on their borrowings. Of course, those companies facing the most difficulties will lose investor support leading to a rapid rise in defaults."

"As we have long pointed out at F&C, the easy money making in credit is over and the winners will be those who get their stock selection right. In such an environment, flexibility of mandate provides a competitive advantage," concluded Robinson.