In this article from The IRS Report in March 2009, Chris Gilchrist talks about corporate bonds.……

Will corporate bonds benefit from Bank buying?

Since the announcement in mid-January that the Bank of England would use us to £50bn buying corporate debt, investors have struggled to work out what this implies for the largely moribund credit market. This hasn't been helped by the fact that the Bank has intentionally released no details at all on how it plans to operate. It does no want to hand free money to speculators, and in this respect at the least the Old Lady is cannier than her American cousins.

The Bank has a wide remit. It could buy up anything from short-term commercial paper - 3- or 6-month loans - through to 10-year bonds. But it will not go below investment grade. Its aim is twofold: to improve the flow of credit to worthy commercial borrowers, and to underpin the now-dysfunctional credit market.

Quite how dysfunctional has recently been revealed by bond fund managers, many of whom have abandoned the automated market price feed and resorted to manual pricing for their portfolios.

Even on A-rated bonds, bid-ask spreads are now anything up to 5% compared with 1% or less in normal conditions. This is causing real anomalies, since a fund suffering redemptions will now be pricing on a bid basis while one attracting subscriptions and holding exactly the same portfolio could be priced 5% higher. Apart from uncertainty over the Bank's plans, there is an even bigger shadow overhanging the sector: bank debt. A large proportion of the corporate debt market is accounted for by bonds issued by banks. The i-shares sterling bond ETF (SLXX) uses an index of bonds that is 60% banks - the Markit iBoxx Sterling Liquid Corporate Long-Dated Bond Index, which holds 86% in bonds rated A or higher. Yet in the sterling market, investors are uncertain about what would happen if banks were nationalised: would they get their coupons and would their capital claims still stand? In theory, they should, at least on all the senior debt. But the government makes the rules. And the Treasury is not keen to give any hostages to fortune.

The Bank is likely to conclude that it would be a waste of time buying bank bonds, which will only recover as and when the issues surrounding bank recapitalisation are resolved, and to focus on A-rated industrial borrowers struggling to refinance their debts. So the initial impact of its purchases may be limited. But if it does effectively underwrite some refinancings at somewhat less than the going rates - which are widely regarded by economists as excessive in relation to default risks - then there could eventually be positive effects on the whole sector.

The two sterling corporate bonds funds I selected last year were Invesco Perpetual Corporate Bond and M&G Strategic Corporate Bond. The divergance in their performance over the past six months is striking. M&G is up 5% (including income) while Invesco Perpetual is down 7.5%.

The reason is bank debt : IP holds a lot and M&G very little. M&G has also kept more of its portfolio in AA or higher while IP has more in BBB. It looks as if the highly-rated Paul Causer and Paul Reed at IP went nap on the banks too early, while Richard Woolnough at M&G stuck to his normal cautious stance. But given how illiquid the markets now are, any turn in bank debt will likely see a very sharp recovery in IP's performance.

I find it hard to see how the UK equity market can recover without there being a significant recovery in the investment grade debt market. And as one manager put it recently, given that BBB and A rated bonds can now be bought at discounts of 30% from their redemption price you should now be looking at the possibility of equity-style returns. So I am steadily adding to my pension fund's holdings in the sector.

You can see all of Chris Gilchrist’s articles at www.TheIRSReport.com.

Chris is the editor of The IRS Report every month.

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