Corporate bonds looking attractive

Jul 21 2008 by Gary Fawcett, The Journal

SO far, it has been a dreadful year for investors with the FTSE All-Share Index down 17% since January 2.

Even the Government All Stocks Index, which consists of treasury stocks, has fallen 3.5% over the last seven months.

Within the last two months alone, the yield on short dated (redeems within five years) gilts has risen from around 4% to 5%, which means the price of some treasury stocks have been falling.

This is due to higher than expected inflation figures which have forced the market into an about change with respect to interest rate expectations.

In April, many commentators believed that interest rates would fall to around 4% by 2009. However, this has changed with some economists believing that the next movement will be upwards, following persistently high inflation figures.

Only on Tuesday we saw year on year inflation running at 3.8%, which was above market expectations. As a result, the Bank of England has been talking tough and has warned that it will not allow inflation to get out of control.

The main cause of inflationary pressure lies in the high price of food and energy. Oil alone has risen from around $85 per barrel in January to $132 on Friday.

However, these high prices are in themselves demand destructive and as long as they stay high, or rise further as some expect, then this will place more pressure on an already weak UK economy. Higher mortgage costs and falling house prices are also weighing on consumer sentiment and this is likely to affect spending.

Consequently, given the dampening effect of high oil and food prices on consumer spending coupled with higher mortgage costs, interest rates could fall to between 3.5% and 4% by the end of 2009. Should this scenario play out then the conventional (fixed rate) gilt market looks set to perform very well over the next 12 to 18 months.

It is not only government bonds that look interesting, but corporate bonds too have some attractions. Following the deterioration in the UK and other developed economies, corporate bond prices have fallen over concern that companies may default on their debt. However, current prices and the yields on offer suggest a very high level of defaults, which seem overly pessimistic.

For the first time in a while, there seems to be potential to make capital growth from this area of the market whilst at the same time achieving an attractive yield. One of the more appropriate ways to gain exposure to this theme is via unit trusts which can invest in a whole array of corporate bonds.

Gary Fawcett is assistant director at Brewin Dolphin, Newcastle