News Archive

I hope that the following commentary by Strategic Gilt Fund manager Ian Williams is helpful for any investor facing the decision between government and corporate debt.
—Andrew Williams, Chief Executive

Last year in an article that was published in the Financial Times I remarked that the smart money in corporate bond funds would be the ones who got out first.(1) As it turns out, in 2008, the IMA UK Corporate Bond sector fell by 10.29% while the IMA UK Gilt sector delivered a positive return of 11.76%.(2) The fact is that 2008 was truly an historic year and very few people, myself included, predicted that in its bid to stabilise the banking sector the UK government would end the year as the sector’s largest shareholder. And though a consensus view has begun to emerge that corporate bonds are too cheap to ignore, I believe what I said in January 2008 still holds true today, although for a different set of reasons. Previously very tight spreads and a looming recession were sound justification for our bearish position. Today we are still bearish on corporate bonds, but why?

It looks as if the downward economic trend is set to continue through 2009. Today’s combination of a tough recession, record government debt issuance, unprecedentedly low interest rates, and a swelling money supply are perplexing even savvy investors. We believe three themes will play out over the next 12 months.

The recession will continue. Very few — if any — career-minded economist would dare argue that this will be a short, shallow slow-down. Across the board, economic indicators from the number of new applications for construction permits to the cost of insuring debt, point to a painful global economic environment for 2009. Historically corporate bond default rates have hovered between 1% and 2%; however, as I’ve said in the past, this number could easily rise to 5% or higher as the recession spreads throughout the real economy.

The yield curve is set to steepen dramatically. Record low yields and record amounts of issuance point to a dramatic steepening in the medium to long-dated segments of the curve. However, short-dated gilts should remain largely unaffected as base rates are certainly not going up and may even fall further. For example, if yields in the long-dated segment of the curve rise from their current 3.8% to 5.0%, then this translates to a capital loss of over 20%. It’s important to remember, however, that the same forces acting on the gilt market simultaneously affect the corporate bond market. An increase in gilt yields of 120 basis points would likely be accompanied by an increase in corporate bond yields, possibly to a lesser degree if corporate bond spreads narrow, but the end result is still value depreciation, and potential negative performance.

Inflation has slowed, for now. The dramatic retreat in the price of oil over the second half of 2008 brought down, in tandem, the rate of headline inflation. This came as a welcome relief for cash strapped consumers and may have been the greatest economic stimulus package of all. However, the price of oil has already begun to creep back up. As the effects of aggressive reflationary measures by governments worldwide — mostly infrastructure spending initiatives — begin to take hold this will only serve to increase upward pressure on general price levels. This in turn, will cause the spectre of inflation to once again haunt the minds of policy makers and investors.

Although corporate bonds seem to be garnering a lot of attention, it is index-linked gilts that could be the consensus play of 2009. These gilts offer protection from inflation while having the distinct attraction of being, at the moment, very cheap. So cheap in fact that as Bill Gross, the Co-Chief Investment Officer of Pimco and manager of the largest bond fund in the world, pointed out in a note to clients on 8 January 2009, the prices of index linked US treasury bonds could sustain deflation of 1% a year for ten years and still break even.(3) Again, the numbers speak for themselves; real yields on short-dated index linked gilts are 1.6% to 2.0% plus the rate of inflation compared to a nominal base rate of 1.5%. In this uncertain investment climate, with regard to both the coupon and the final redemption proceeds, locking in a set coupon that is protected from inflation and at a price that is cheap in historical terms seems like a savvy home for cash. This is particularly true when compared with the prognosis for corporate bonds whose price will suffer if the yield curve steepens as expected, regardless of what might happen to credit spreads. Short-dated index linked gilts offer a potential higher reward than corporate bonds with a much lower level of risk.

1) Gilt-edged year predicted, The Financial Times, 22 January 2008
2) Source: Lipper
3) TIPS Irresistible to Gross as Protection is Cheap, Bloomberg, 12 January 2009