29th July 2016
Gordon Shannon, portfolio management, Twenty Four Asset Management, considers the performance of investment grade portfolio bonds in the last month.
As it turned out July has been an exceptional month for £ investment grade corporate bonds….we’ve been asking ourselves if August will be the same? To date the BAML £ Corporate Bond index has returned 4.92% and yields are 49bp lower than where they started the month.
To answer the question we have to look at why July was so strong.
Firstly, as we can see from the graph below, £ corporate bonds were already weaker than their foreign equivalents as Brexit fears had become embedded in their yields. Additionally, as we know, Brexit was the eventual outcome from the referendum in June, and consequently markets went initially into a very strong risk off mode. This provided a great platform for Gilts to perform, despite some nervousness about how the UK may fund itself in the future. The Bank of England’s prompt reassurance to the market should receive some of the credit for this. Expectations of a rate cut on August 4th and possibly further action from the Bank ensured that Gilt yields were underpinned throughout the month of July, while some other risk off markets saw their yields increase. Investment Grade corporate bonds trade as a “spread over Gilts” so the Gilt performance was an important contribution to the return.
Moving on to the credit component, as this is where the bulk of the return has come from in IG corporates in July, credit spreads contracted sharply as markets staged a powerful risk recovery. As I write, they are 36 basis points tighter at the index level over the course of the month. Again as we can see from the graph below, a similar, but not quite as strong a tightening has been seen in Euros.
We think it is right that £ performed better and the reason once again lies with our Central Bank. In an early address in July Mark Carney was keen to point out that the Bank would be considering all tools at its August meeting. In particular he pointed out that the Bank would be closely watching the availability and price of credit. Our take on this was that if either the availability of credit reduce or its price become higher then the Bank of England could seek to address this via corporate QE. A guard against unintended tightening of financial conditions. Very well done again Mr. Carney.
Consequently when we form our outlook for August in IG corporates, it is clear that they are still cheap to their foreign cousins and that there is room for this yield to compress further in the knowledge that the Gilt curve stands to benefit from a rate cut and possibly a reopening of the Gilt purchase programme, and that the credit spread is somewhat backstopped by a Central Bank on its guard for spread widening.