Investment Grade Bonds
- Crisis or Opportunity
for 2008?

For the first time in 3 years there is value once again in the corporate bond markets. After a very difficult 2007 it looks like 2008 is shaping up to be a much more interesting year. The positive outlook for corporate bonds will be supported by the following:

Central Bank monetary tightening is behind us and official rates are headed lower.

The yield premium over government bonds more than compensates for the rise in risk.

Greater willingness to retain credit quality

The investment grade corporate bond market has substantially underperformed the government bond markets in 2007, making the yield gap between the two very attractive (see green line on the chart above). Since the major credit events of the turn of the century you have never been rewarded with so much extra yield for taking on the risk of owning Investment Grade corporate bonds.

Of course not all corporate bonds are the same. The main catalyst for the spread widening in 2007 has been the deterioration in the fortunes of the banks but industrials returned a meagre 2.5% in 2007 versus 5.2% for gilts. The banks are the bedrock of the credit market so when they are affected the rest of the market is influenced. The cutting of interest rates by central banks from 2000 to 2003/4 led to a growth bonanza for the banks. The low return world led to investors seeking leverage to boost their returns. They were used to getting double digit returns and with the help of their friendly banker they could achieve this by bolting on a bit of leverage but often sugar wrapped as a AAA security. From CDO managers to private equity investors, money market funds to pension fund investors, the amount of return you wanted was just dependent on the size of the leverage used. The whole system was outside of the normal control of the central bankers until it all started to unravel earlier this year. The US housing market was spurred on by crazy lenders who were willing to lend to anyone with a pulse. The US housing market turnaround started a chain of events that has gripped the world's financial system since February last year.

In the short-term the headlines about write-downs will continue as we move through the Financials' key reporting calendar. By the time the Q4 numbers are out the reality may not be quite as bad as feared. The cumulative write-down figure for the banks is over $90 billion and this is before all banks have come clean on their 4Q exposure. Having arrived at a point where all credit is bad and all asset backed securities are deemed to be worthless it seems appropriate to review how much bad news is priced in to markets.

The economic outlook can have a significant influence on the direction of bond markets. As the US slowdown mutates into something more serious we will see an out-performance from high quality bonds. The return on a 'AA' rated bond has a higher correlation to the level of official rates than it does to the weakening outlook for corporate profits. The best absolute returns come in periods of economic weakness.

If the world economy doesn't catch a cold from the US housing disease and the central banks are able to keep the momentum going then once again high quality corporate bonds will do better than their government equivalents due to the higher yields.

Company behaviour can also be a significant factor. During the recent LBO heyday corporate bonds were vulnerable to reckless company managers who re-leveraged their balance sheets by giving money back to share-holders rather than paying down debt. Leverage is now a dirty word and in the case of the banks their focus will be on how to reduce leverage from here by cutting dividends, selling assets and injecting fresh capital from new Asian shareholders. Our analysis suggests an improvement in credit quality (and hence in the price of the bonds) is a necessary precursor to an improvement in bank share prices. In the last downturn (2002-3) investment grade corporates returned an annualised 8.88% for 3 years (source: Merrill Lynch)

With the major central banks and the US Government keen to resolve the current crisis in bank funding (ECB injects €300 billion - that's €1,000 for each one of the population) it is only a matter of time before they are successful. Once the liquidity crisis is resolved corporate spreads will narrow. BUT there are some simple rules to follow:-