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Home > Investments > Fixed Income

Fears for corporate bonds as dip threatens UK AAA rating

Managers warn that corporate bond markets look vulnerable as UK goes deeper into recession

By Bradley Gerrard | Published Jul 30, 2012 | comments

Fund managers have warned that corporate bond markets look vulnerable, after the government admitted that the UK was in a deeper recession than even the most bearish economists had feared.

Several managers – including those who run bond funds –spoke out as the IMA said corporate bond funds had continued to dominate retail sales last month, netting £223m of inflows.

But official estimates suggested that the UK economy contracted by a shock 0.7 per cent in the second quarter of 2012, threatening the government’s ‘austerity’ programme and AAA rating.

If the UK loses its AAA rating, the country could lose its safe haven status with foreign investors and gilts could plummet. This may pull the rug out from under ultra-popular investment-grade corporate bonds – which tend to be priced in relation to gilts.

Following the credit crunch, liquidity in the corporate bond market has been poor, meaning prices can be volatile during periods of stress such as the euro crisis. The FSA recently sent a letter to corporate bond fund managers over the issue, while last week M&G Investments moved to limit inflows into its corporate bond funds following vast inflows.

Robin McDonald, co-manager of Cazenove’s multi-manager range, said if UK government bonds suffered price falls then “corporate bonds of any reasonable duration would indeed be vulnerable”.

“The higher quality the corporate bond, the more vulnerable it would be as there is no spread buffer,” he said.

The manager has removed all exposure to the highest-rated investment grade bonds – normally seen as the safest place to invest outside of governments –as the risks “far outweigh the potential returns”.

“What bonds we do own are lower-quality, and more sensitive to the behaviour of the economy or risk appetite than any direct movement of gilt yields in either direction,” he said.

Ignis Asset Management’s head of credit Chris Bowie said the corporate market could be vulnerable if the UK’s rating was cut sharply to single A – particularly the banks as “they have such a strong link to the government” following the bailouts of the past five years.

He warned that the corporate bond liquidity situation was “challenging” – to sell roughly £100m worth of bonds now takes several days or even weeks, he warned.

“That does give me cause for concern that if there is a big run on the asset class and lots of investors all want out, I think liquidity will become a larger issue.”

Phil Milburn, fixed income manager at Kames Capital, said government bond markets would continue to be supported by institutions such as banks, pensions funds and overseas central banks in the event of ratings downgrades.

But he said “if [government bonds] do sell off then sterling corporate bonds will sell off”.

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