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Home > Opinion > Nick Rice

UK woes show pitfalls of passive push into credit

Fears over UK GDP affect gilts, which coupled with the euro crisis may hit corporate bonds.

By Nick Rice | Published Jul 30, 2012 | Investments | comments

If anything can dampen the Olympic spirit in the UK – aside from London’s creaking infrastructure – the double-dip recession must be the top candidate.

The UK’s economic growth data last week – estimating that GDP shrank by 0.7 per cent in the second quarter of this year – was, in the words of fund house Schroders, “simply awful”. Extrapolating from recent Olympics data from FundExpert.co.uk, the games will not be enough to push the UK into economic growth in the third quarter if the dismal trend of the previous nine months continues.

Given the parlous state of the UK’s government finances, and the ongoing bubble in the UK government bond market, it is understandable that the coalition does not wish to ramp up public spending excessively to bolster GDP. But it is also inexplicable that it is not doing more to facilitate supply-side reform – to enable sustainable development of the aforementioned creaking infrastructure, for instance. The limits of monetary policy in stimulating growth – as opposed to inflation – have clearly been reached. Foreign investors in gilts, a decent proportion of the total, may start to get nervous.

If anything can dampen the Olympic spirit in the UK – aside from London’s creaking infrastructure – the double-dip recession must be the top candidate

Advisers might rightly ask what this slow motion government train wreck has on their clients’ investments. The answer is, “more than they might think.” Although advisers have not proved particular fans of gilt funds, they have flocked to investment grade sterling corporate bond funds over the last few years – partly as investors and regulators have passively followed backward-looking asset allocation models that tell them investment grade bonds are necessarily low risk.

Unfortunately for advisers, gilts are the bedrock on which these other bonds are priced. Moreover, fixed income markets have been relatively illiquid since the credit crunch, and nervousness over the euro crisis in particularly is making matters worse.

When valuing corporate bonds, investors in the market talk about two measures, their yield and their spread, or the difference between their yield and the yield on gilts. If gilts fall and the yield on gilts rises, yields on corporate bonds come under pressure to rise in tandem. Under certain conditions, the spread will contract – meaning that if the gilt yield rises, the corporate bond yield can stay the same or even decline. But if the spread does not contract, woe betide anyone in corporate bonds.

This is not just a technical point. There are sound fundamental reasons why many corporate bonds are priced off gilts. As the UK has seen in the past five years with financial firms, there are a number of companies that the government simply cannot allow to fail – most obviously utilities and dominant food distributors such as Tesco. Much of the risk of them defaulting is the risk of the government itself going bankrupt.

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