James Gledhill, head of fixed income at New Star, looks at the current economic environment and provides his views below on the implications for fixed income markets. James explains why the New Star bond team is currently favouring bank debt and why he believes that corporate bond yields are offering good value for the medium and long term investor.
The Bear Stearns rescue, while not signalling the end to the credit crisis did lay the foundations for its solution. From that point on it became clear that the authorities were prepared to take firm action to support the financial system, although clearly at a price. The low-ball offer made to Bear Stearns shareholders by JPMorgan meant the US Federal Reserve could defend itself against accusations that any bail-out would encourage excessive risk taking - the so-called moral hazard.
Similar moves have been undertaken in the UK. The Bank of England, in tandem with the UK government, ensured that Northern Rock did not fail, although shareholders are still awaiting the verdict on whether they will receive much, if anything, for their residual ownership. More important, perhaps, from the wider view of the market has been the establishment of the Special Liquidity Scheme (SLS). This permits banks to swap less liquid assets such as mortgage books for universally accepted UK government bonds. One of the principal problems of the credit crisis has been the loss of confidence in asset quality at banks. Anything that alleviates these concerns and improves liquidity is therefore useful in restoring a fully functioning money market.
Such generosity by the authorities usually comes with strings attached. In the long run this will probably mean greater regulation and the end to some profitable but riskier business lines. Shorter term, it seems that banks have been leant on to come clean about the extent of their losses and improve their capital positions. This has led to a number of rights issues, the biggest of which has been the record £12 billion raised by the Royal Bank of Scotland. Other banks are following suit. This should help restore capital ratios and provide a buffer against the forecast short-term deterioration in the economy. Such capital raisings are good news for bondholders since it increases the level of equity capital in a company, reducing the likelihood that companies will default.
In time, as confidence grows in the banking system, this should help to narrow the gap between LIBOR, the rate that banks are prepared to borrow from each other, and the Bank of England's official bank rate. How quickly this happens depends on the wider economy. A spoiler has been the up-tick in inflation. At New Star we have been warning for some time that inflation was likely to creep up and that bond portfolios needed to have some cushion against interest rate risk. To this end we had limited exposure to government bonds which are more sensitive to interest rate risk. This position did not help in the flight to quality of 2007 but has proved correct more recently with the 7 percentage points fall in the 10-year gilt since mid-March.
We are, however, broadly in agreement with the Bank of England's assessment that the spike in inflation caused by commodities will be short term and begin to ease off next year. So far, the high oil price has not had the expected demand response. In part this is because there is a lag in accepting prices will be higher and consumers have therefore not yet adjusted their behaviour. Signs are beginning to emerge of a demand response, most notably in the airlines cutting capacity. On the other hand, the price impact has been cushioned by subsidies on fuel in emerging markets. Several countries, including Indonesia, India and China have announced a reduction in these subsidies, however, and as the real cost hits home this should begin to trigger weaker demand over time.
For the next couple of years we are anticipating slow growth and higher inflation. Such an environment will not be crippling but will feel uncomfortable and is likely to create some interesting investment opportunities. Currently, we favour bank debt. Yields on bonds issued by the Royal Bank of Scotland, for example, are trading at 250 to 350 basis points more than the corresponding government bond. For instance, the 10-year gilt was yielding 5.3% in mid June, compared to a yield of more than 8% on a Royal Bank of Scotland bond maturing in 2018. While the bank's bonds clearly carry more risk, it is highly unlikely that the company will default.
Outside of bank debt we favour high yield bonds, many of which are offering yields in double figures. Such yields provide a good cushion against inflation although we would caution against buying bonds in more cyclical companies given the expectations of a weakening in the global economy that could lead to lower earnings. Our preference remains for bonds issued by companies with predictable cash flows rather than companies with lower borrowings but more cyclical earnings.
There are likely to be wobbles in the market for the remainder of this year as credit markets attempt to ascertain the true cost of the credit crunch and the extent of the global economic downturn. Nevertheless, we believe that investors prepared to have a medium term investment horizon will look back on the corporate bond yields on offer today and reflect on what good value the market was offering.
Past performance is not necessarily a guide to future performance. The opinions expressed here represent the views of the fund manager at the time of print and should not be interpreted as investment advice. This document is for professional advisers, professional investors and financial institutions only and is not to be relied upon by private investors. Issued by New Star Investment Funds Limited.