January 2009 Market Update - Fixed Interest Markets

Most fixed interest markets, other than the US government bond market, had a difficult time in 2008. Indeed disappointingly, many corporate loans behaved more like equities than bonds. This was due to that fact that the corporate bond market suffered immensely from the liquidity squeeze as described earlier, with a near buyers’ strike forcing bonds to huge discounts to their face value. It is probably worthwhile, therefore, to take a look at the workings of how corporate loans, or corporate bonds as they are known, work:

A corporate bond is a loan taken out by a company which is then traded on an exchange. Buyers and sellers take a view as to the quality of the company, its ability to meet interest payments, to repay the final capital and the direction of future interest rates and inflation. Importantly, unlike equities, bonds generally pay a fixed amount of interest and have a fixed duration (like a mortgage). Equities do not have an end date and the income, in the form of dividends, is paid out at the discretion of the board. Therefore, the price of a share should fluctuate by a greater amount (have greater volatility), since there is greater uncertainty than a bond.

Historically, corporate bonds have traded with an income level around 2 to 5% above that of bonds issued by governments to reflect the difference in risk. Given that government bonds in Europe are yielding 3 to 3.5% it is therefore somewhat surprising to see corporate bonds yielding around 9 to 10% with some yielding in excess of 20%. This increase in yield has been met with a corresponding decline in the traded price of the bonds. On the face of it this would indicate a belief in the market that the majority of companies which have issued bonds will be unable to meet their interest obligations. However, on discussion with highly experienced fund managers in this field, we believe these exceptional yields are being driven higher by the rush to raise liquidity, not the fundamental outlook for the companies. Therefore, once the economic picture has become clearer there may be a marked recovery in the funds which we hold and possibly the opportunity to take advantage of this through further investment. Meanwhile, with the funds that we hold we are receiving a healthy level of income to compensate for the volatility and we know that the prices should recover as we approach the redemption (paying back) of the bonds by companies at the end of their life, in 3-4 years on average.