By ROBERT HARLEY 17/11/2008
Since the collapse of Lehman Brothers, the fourth largest US investment bank, in mid September, all risk assets have experienced marked falls. Even quality bonds, traditionally perceived to be more of a safe haven in uncertain times, experienced a notable weakening in price as their risk premium or spread over UK Gilts widened significantly, resulting in high single figure losses. At one point it appeared that confidence in the financial system was at breaking point, forcing the hand of governments globally to adopt a more radical interventionist approach to underwrite the global banking sector. So far this move has had the desired effect of stabilising credit markets, albeit spreads still remain at elevated levels.
Part of the reason for the high level of pessimism suggested by quality bond spreads has been the high incidence of forced selling as a result of de-leveraging. This has resulted in prices being driven down to levels that many managers consider to be irrational. In spite of the negative fundamental outlook, where the only question seems to be how bad the current recession will be, our belief is that quality bonds are now pricing in an extremely gloomy scenario, and arguably offer the most attractive risk / reward outcome amongst all the risk assets classes. From an equity holders perspective, as earnings weaken dividends will be cut before interest payments on bonds are missed, whilst bondholders retain a residual interest in the event of bankruptcy.
Admittedly, it is possible that the poor technical conditions which have plagued this market will persist for some time. In addition the credit market is faced with the prospect of a wave of new bond issuance as banks and corporates seek to rebuild balance sheets. However, at the same time, the continuation of poor economic data is likely to apply more downward pressure on government yields which could compensate for any further spread weakness, whilst the prospect of further cuts in interest rates should encourage investors to seek higher yielding assets as an alternative to dwindling cash returns. Quality corporate bond funds now offer redemption yields of just over 7.5% after charges - akin to longer term equity returns. Given the market backdrop we believe it is unlikely that equity markets will be able to mount any sustained rally until credit markets are fixed. Consequently investors should give consideration to allocating a higher percentage of their portfolio to quality bonds than has historically been the case.
