Bond market calmer but threats to stability remain real

Last year was tough for corporate bond funds, normally known for their steady unassuming performance and stability compared with more volatile equities. Justine Fearns, Research Manager at AWD Chase de Vere, explains why many lost capital and says the outlook for 2007 is better, but not brilliant.

In 2005, AWD Chase de Vere warned investors that the good times were temporarily suspended for Corporate Bond fund investors. The return of the roaring equities market, rising inflation and interest rates, and the downgrading of some seriously big corporate bond issuers, all hit the market.

The predictions proved true. The 2006 bond market was also exceptionally volatile and many UK Corporate Bond fund managers actually lost money as they fought to maintain decent income payouts to investors.

“Although the number of corporate bond defaults fell to record lows, the difference in cost between investment-grade and high yield bonds just got narrower. As markets twitched, those in the wrong bonds at the wrong time saw their values fall, causing losses on the funds.” says Justine Fearns.

The pressures

Short term bonds (maturing in under a year) were hit early in 2006 as markets dithered over inflation and interest rate rises. From January to March, gilt markets were volatile as opinion swung between more rate rises or a peak. Existing short term bonds looked expensive and prices fell as new issues had bigger yields. They bounced back when everyone thought the pressure was off.

Long term bonds (ten years or more) tend to pay out higher yields, but ravenous pension funds desperate to match their far-off payout liabilities with lower risk investments pushed prices way up as demand outstripped supply.

In technical speak, this super-demand ‘inverted the yield curve’ resulting in long dated bonds currently paying out less than short term ones.

Corporate bond spreads, the difference in payouts between investment grade and high yield, also tightened from already narrow levels. Defensive investment grade bonds were in demand, but so were high yield issues as good economic growth lowered the risk of companies defaulting on their payments. And overseas investors, particularly the Japanese who had faced 0% returns at home, bought US and European bonds by the bucketful, keeping up demand pressure.

“Almost every investor around the world was chasing yield in 2006. With all global economies in generally good shape, buyers did not care where it came from – long, short, quality or high yield. This pushed the prices of every type of bond far closer together, making it hard for individual fund managers to maintain their edge over competitors and to steady their yields. Some even lost money as their bets went sour in choppy markets.” addsJustine Fearns.

The UK Corporate Bond sector fell 2.72% in the first six months of 2006 and every single fund lost money. The best were down just 0.61%, the worst including several long-dated funds fell by almost 8%.

July to December proved a happier time but still volatile for many funds. The sector bounced back 2.09%, led by Margetts Greystone Fixed Interest (+3.89%) and Old Mutual’s and Invesco Perpetual’s funds up 3.33% and 3.29% respectively. Long dated funds faired better as pension fund demand pushed up bond prices.

Overall, the UK Corporate Bonds sector rose only 0.71% in 2006, with just 19 out of 91 funds posting gains. Individual performance ranged from +2.71% to a loss of 5.09% for the S& W Nucleus Fixed Interest fund.

The outlook

Managers are split on where the market will go. Philip Milburn, who heads five funds in the £1 billion bond portfolio at AEGON, is cool, calm and collected. He says “The market has a tendency to predict extremes but our honest view is rather calm. We are happy to be dull.”

”Bond markets sold off in December as economic data came out stronger than many had anticipated. The market now looks better value across the curve. Although it is unlikely the long end will outperform in 2007 to the same extent as it did in 2006, long dated bonds will continue to be underpinned by pension fund buying.” adds Millburn.

That may be so, especially in the US, where there are fewer long dated bonds but just as much pressure on pension funds to match liabilities. On the other hand, Quentin Fitzsimmons at Threadneedle does not dismiss shorter maturities.

“Short dated bonds are looking more attractive as inflation will not be a problem. Significant global competition should keep European wage growth down and therefore hold inflation in check. If rates are not at their peak, they are very close.” he says.
He worries about the Japanese, firstly because they might stop feeding demand for Western bonds if the Bank of Japan ups domestic rates but also about oil, which has become a real wrecker of bond market stability.

“Just a few years ago, high oil prices were seen as a tax on consumption. In 2006, the extent of price rises meant sentiment changed, sparking fears on inflation and a wage price spiral. Bond markets took fright and could do again if the same happens in 2007.” he warns.

Overall the outlook for corporate bonds is good but not brilliant, says Chris Bowie of Resolution Asset Management’s UK Corporate Bond fund.

On the plus side, companies remain extremely profitable despite one or more potential base rate rises this year. What’s not so good is that corporate bond spreads look tight and would need a re-acceleration of growth or demand to widen spreads. At least, he says, Government bond yields have risen substantially by 75 basis points or so, making the whole asset class more attractive.

Bowie predicts “Over the next 12 months, I’d say corporates will beat Govvies, high yield will just beat investment grade but it will be close, and bonds will beat cash but not equities.”