Fixed Income  

Investec: Shop around for bond alternatives

Much has been written about the tapering of quantitative easing in the US, the unwinding of gilt purchases in the UK, concerns around inflation and the impact on bond prices when the economy - and interest rates - revert to more normal levels.

When it comes to discussing investment grade credit, most commentators acknowledge that credit spreads - the difference between corporate bond yields and government bond yields - remain attractive with the potential for long-term tightening.

In other words they recognise that, as interest rates increase and the world returns to normal, we should also see the cost of raising funds for companies decrease.

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The question remains, however, as to whether this spread tightening will compensate investors for the expected increase in the yield from gilts.

This debate is quite topical following the announcement of forward guidance this month by Bank of England governor Mark Carney. If interest rates do stay low then one would expect to see long term credit spreads tighten as the economy recovers, but equally one would expect long-term underlying gilt yields to increase.

It is almost universally accepted that the long-term risk free rate - ie the gilt price - embedded in long-dated bonds carries the greatest risk to bond prices: when gilt yields rise, bond prices fall. Investors should arguably be on a quest for investment opportunities which can hedge away the interest rate risk of rising gilt yields, but remain exposed to the shrinking credit spread in corporate bonds.

Most investors have at some stage in their life taken out a mortgage. The majority still have these loans as part of their household balance sheets. There is a plethora of opinion that debates whether it is a good time to refinance, and/or fix one’s interest rate exposure.

But very few alternatives are available when investing in bonds. In an ideal world investors would have the same simple choice as mortgage buyers: being able to not only pick the bond they would like to invest in, but also choose a fixed, floating or inflation linked basis for their coupon payments.

Most bonds are issued on a fixed rate basis, and those looking for inflation or floating rate returns often have to look elsewhere. Choice is limited, and inevitably involves additional management charges in a world of low absolute returns.

Increasingly investors are limited to:

• Funds run by managers who often manage interest rate risk through the use of derivatives;

• Investing in less liquid, sub-investment grade - high yield - funds;

• Investing in short duration fixed income products such as exchange-traded funds;

• Holding short-dated bonds, money market funds or cash;

• Investing in riskier equities in a bid to beat inflation.

Most of these alternatives suffered when interest rate shocks led to dramatic moves in the bond market, exacerbated by record outflows in the month of June as retail investors exited fixed income funds.

However, with credit spreads remaining at attractive levels and likely to tighten, we still believe bonds hold value and most investors should continue to hold quality corporate bonds as part of a balanced portfolio.