No bad news? Make it up!
Brian Dennehy
On 18th August the Telegraph featured the headline:
"Morgan Stanley issues alert on corporate
bonds after explosive rally”.
That got the phones ringing as it went on to say “according to a report by Morgan Stanley they look increasingly vulnerable as they pull far ahead of equities”.
What they actually said was that they were “tactically moderating enthusiasm” for non-financials on a one month view, but looking beyond that (into September, where we are now) they remained optimistic.
To summarise the Morgan Stanley view earlier in August, fill your boots with bank bonds* and other financials, but don’t be surprised if non-financials are dull until everyone is back from their hols.
Morgan Stanley and others continue to highlight that although investment grade bonds have bounced very sharply since March, they are still priced for recession, albeit of a “normal” variety rather than Armageddon.
There are a number of ways to observe this continuing potential.
For example, according to Merrill Lynch the average investment grade bond at the end of July was yielding nearly 100% more than gilts, whereas two years ago this gap (risk premium) was just 20%.
Looked at another way, many bank bonds (the drivers of performance since March) are still in the range of 60-70p. Conservatively there appears to be another 10-20p of upside, suggesting a further capital gain of, say, 15-30% on this sub-sector. This highlights again why funds with high weightings in bank bonds should be your focus if you are chasing the upside in bonds, rather than pursuing capital preservation.
Even if bank bonds move into the 80-90p that still leaves them shy of 100p in 2007, and 2006 when they traded around 110p (based on the iBoxx subordinated bank bond index). The global banking system has been taken to the brink since then, so a discount to that earlier peak seems wholly appropriate. Equally we should not expect bonds to continue to make progress as quickly as they did from March to this point.
And last but not least, do remember that taking on the potential for more reward means taking on more risk - there is no free ride.
This article was published in the latest issue of BondWatch, our monthly e-bulleting tracking dvelopments in corporate bonds and corporate bond funds. For a free copy email erica.chapman@dwcifa.com - no formalities required.
* they were also careful to distinguish between those banks owned by the state or requiring state aid, representing 20% of tier 1 bonds, and the rest
Date: 11.09.2009