Corporate bond market outlook from F&C

The corporate bond funds and Strategic Bond in particular have been well placed to weather the storm of the last few days.

The events in China primarily highlighted the huge rally we have seen in risk assets globally and the need for a correction as most credit markets were over leveraged. For bond investors the real issues are for example, the low end consumer in the US who is starting to feel stretched. And the flow of Private Equity deals which are seeing companies taken out with little or no injection of equity but with balanced sheets loaded down with debt.

The bond markets are starting to mirror the concerns in these areas despite the fundamental back-drop for credit, which is still largely positive.

The market correction is something we have been anticipating for a number of months. As a result, we have for some time been selling down some of the riskier higher beta names. This process accelerated in the second week of February when the ITRAX Crossover Index fell to an all-time low of 170, since when it has rallied 50 points to 220.

Not surprisingly, Gilts have rallied of late, which was good news for our investment grade holdings.

Portfolio weightings
Current weightings of the portfolio are as follows

43% Investment Grade
45% High Yield
7.5% Not rated – But our rating classes most as investment grade.
4.5% Cash

Within high yield we have 8.2% in Floating Rate Notes which have calls due later in 2007 or in 2008 so volatility is low. In addition, the overall duration of our high yield portfolio is short with 18% due to mature within three years and a further 24% due to mature in the next three to five years. This again has helped limit volatility.

In terms of the highest risk CCC holdings, each is held for a stock specific reason that we remain comfortable with, for example Jefferson Smurfit is due to IPO shortly.

Activity
In terms of activity we have been cutting back on our high beta holdings by selling down names such as semi conductor company Freescale, Telecom Italia 2033, Cell-C and Mecachrome, while adding to AAA rated Cumbernauld.

In the coming weeks we will be looking to trim further our higher beta names into market strength and add to favoured short duration and lower beta high yield names on market weakness. For example, we recently added US waste management company Allied Waste to the portfolio.

Elsewhere, Moody's earlier this week, announced that they were going to give the leading banks in each country a AAA rating. This is on the basis that none have ever defaulted and it is likely that governments would intervene to prevent any of them going under. This saw the financials sector as a whole post a strong rally and we are well represented in this area.

Outlook
While the overall backdrop for credit remains positive, the wild card for credit markets is not events in China but rather any unexpected deterioration in US economic growth or inflation numbers.