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Bond of the Week: 10 January 2013
Where to Guv?

Over Christmas I tumbled into a cab. The driver leaned towards me: “Where to Guv?”.  I feel that is what you the reader are asking me now. You may not be of course, but I feel you are:  “Where to Guv?”. Whither goeth the bond market this year?

It is always good from time to time to stand back from examining individual bond issues and reflect on the bigger picture. The New Year is as good a time as any to do this. This year the question of where the bond market is going seems particularly pertinent. There have been quite a few articles suggesting corporate bonds are an accident waiting to happen. Too many investors have piled in. Yields are too low. Liquidity is poor. And it is certainly true that the yield of the average bond is distinctly unexciting.

I talked to a market maker today and he started to ponder about his own p.a. bond holdings. Should he go with the flow, dump the lot and switch into equities? It is certainly easy to be carried along on emotion when investing and it is true investing is as much an art as a science. However, before we abandon the bond market and join the flock, let us try some broad brush analysis.  What do we know or can we make a calculated guess about with regard to the year to come?

  • Short term interest rates in major economies are very unlikely to rise.
  • Governments will not solve their ever increasing debt problems.
  • UK growth will be poor.
  • The UK cannot afford its borrowing costs to increase much from current levels.
  • We are not moving towards deflation in the UK. Inflation in the UK is likely to move up a little from the current 2.7%.
  • Workers will be unable to respond to moderate inflation by pushing through inflation busting wage rises.
  • The Bank of England will keep the ability to have further QE in its arsenal.
  • Post QE there is plenty of money around the system looking to be invested.
  • The hunt for yield will continue.
  • Corporate balance sheets will remain in good shape.
  • Banks will continue to improve their capital ratios and their liquidity will remain strong.

The first observation is that in many ways it is more of the same except perhaps with some of the (shorter term) risk removed. It is clearer than before that governments (the EU in particular) are prepared, even if at the last moment (the US fiscal cliff), to take whatever measures (Bank of England to target growth?) necessary to keep the show on the road.

Taking from the above bullet points what can we devise? If there is feeble growth in 2013, the UK will be no nearer and quite probably further from solving its debt problems. As the deficit will remain and the overall debt burden will compound up, the government will not be able to afford paying much higher interest rates. Therefore notwithstanding any other reason (need to keep Sterling low to engender growth etc.) short rates cannot rise meaningfully. If short rates cannot rise there is a limit to how much long rates can rise. A steeper yield curve will bring yield hungry buyers tumbling into the market. And if not, in extremis, QE can be used to keep the lid on; so either way interest rate rises should be contained.

What about inflation substantially pushing up yields? Inflation is a concern but as in previous years it is unlikely to turn into generalised wage inflation especially with public sector wage growth constrained to 1% per annum. That means that not only will there be no need for the Bank of England to respond to 2, 3, or even 4% inflation with rate increases, inflation itself will suppress the standard of living which will suppress the growth outlook and therefore the desirability for an increase in Base Rates. For investors the real issue with inflation is not the fear it will up-end the whole market but instead it is to make sure you get a positive post inflation return. Otherwise it is not much of an investment!

But what about the credit spread? Can there be a large sell off in corporate bonds? Strong corporate balance sheets and ever more cautiously run financials suggest (taken collectively), there is unlikely to be a sell off for credit reasons as there was in 2007-2009. Then it was a case, at least as far as financials were concerned, of market makers and institutions finding a bid, any bid, and hitting it. That is very unlikely to be repeated. The relative financial strength of corporates vs. governments should continue.

Finally a word on liquidity. There hasn’t been much liquidity for institutional bonds on the way up so it would be unreasonable to expect much on the way down (whenever down comes). Most purchases of bonds by institutions now come by way of investing in new issues. This illiquidity is, of course, one of the consequences of leaning incessantly on casino banking. The banks withdraw capital from market making and hence run much smaller books. However, assuming no sudden unforeseen event bringing into question the credit worthiness of a whole sector, I don’t see why any retreat of prices should be disorderly. If yields increase I am sure there will be ready buyers, starved of return and waiting in the wings. Any institutional reallocation of funds from fixed income into equities is likely to be self-corrected by even a modest increase in rates. Pension funds and life companies are conscious of the much higher volatility of equities and remain under regulatory pressure to be cautious and therefore they are fully attuned to the attractiveness of bonds should they be able to capture higher yields.

So where does it leave us? While the returns that have been achieved this year are unlikely to be repeated (the model portfolio run by Stockcube returned 18.2% for the year), pitched carefully bonds can serve you well in 2013. It is quite conceivable that gilt yields could increase (2.5% for the 10 year??) but not by a great deal. The better the credit the lower the spread over gilts of a corporate bond and the more likely you are to suffer a price decline. Therefore I would buy bonds with some credit cushion and I would avoid very long maturities unless the yields are exceptional (sadly that is rare today). I also think it quite likely that given the unrequited desire for yield a further contraction of credit spreads can be expected and indeed a rise in gilt yields may even increase this likelihood as buyers concentrate on absolute not relative yield.

It seems therefore that this all points to retail bonds. They are liquid in sizes you may wish to deal in, their maturities are reasonable and the yields are none too shabby. The issuers are often not all that well known and the companies can be smaller than those that issue in the institutional market but you are rewarded for that via higher coupons. All the issues that have managed to launch this year have had a good or at least reasonable credit story. On average I would expect to continue to be able to make some capital gain on retail new issues. In December the (real money) model portfolio liquidated some of its older more expensive and less liquid issues and is sitting on cash which Stockcube is targeting to invest in new issue retail bonds. They are putting their money where my mouth is! Retail bonds also give a positive return versus inflation and achieving an absolute real return must be the basis of bond investing.

While I am optimistic on at least a part of the bond market, I cannot comment on how they may perform against equities. My only thought is that whereas bond returns rely on maths and value, equity performance depends on hope: the hope of superior company performance and the hope that somebody somewhere will buy your shares from you for a higher price at a later date. Seen in the wider economic context hope is in short supply today and the most frequently expressed reason to buy equities is a bond reason – buy the dividend yield; equities yield more than bonds. It is an attractive idea but it could be a trap – further bad economic news (surely there must be some in 2013) will affect share prices more than bonds. I keep an open mind on equities.

My positive outlook for the bond market could of course be seriously thrown off kilter if there is much better than expected growth in the UK and elsewhere. This would lead to a sustainable improvement in government finances and therefore an ability to normalise interest rates. This is possible but I think my taxi driver would say “Cor Blimey Guv’nor, pull the other one.”.

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.

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