Is Now The Time To Back Bonds?

For those of interested in baseball, we're not talking about the big hitting left fielder for the San Francisco Giants, Barry Bonds.  No, we're on the subject of the bond market - in particular, investment grade corporate bonds.

The recent credit crisis and its effect on global equity markets has been a major news feature in recent weeks.  There is still no clear indication as to the extent of the problem - the uncertainty surrounds who holds how much of the bad US sub-prime debt.  It's not just equities that have had a rough ride recently; however, bonds too have had a particularly bad time over the past 6 months.

Bonds are debt instruments issued by governments and corporations (some other agencies like local authorities and supra-national organisations may also issue bonds).  It is important for the strength of the economy that capital can be raised easily and relatively cheaply.  In many ways the bond market (particularly corporate bonds i.e. those issued by companies) underpins much of what goes on elsewhere in the economy.

The uncertainty concerning the extent to which banks will be exposed to the sub-prime sector, has led to a substantial drop in the demand for the bonds issued by banks (i.e. the banks debts).  If one considers that a bond issued, by say Barclays Bank Plc, would normally be considered by the market to by relatively low risk (by which we mean creditworthy), the current situation whereby investor are demanding a much higher rate of return for taking on bank debt can be seen as unusual.

An increase in the return investors demand from their bonds is reflected in the term "widening credit spread".  Credit spreads on investment grade corporate bonds are now wider than they have been at any point since 2002, according to Old Mutual Corporate Bond Fund Manager, Stephen Snowden - meaning that those buying corporate bonds now seek a higher rate of return (i.e. interest) on a bond, compared to that available on a comparatively dated government issued bold (gilt).

According to some (Snowden included), the current situation is illogical if you believe that ultimately the effect of the credit crises will not be as bad for the banks as others are making out.  If you think that many investment grade bonds (those deemed by the rating agencies to be financially strong and credit worthy) are being too cheaply valued at present, then the current environment represents a buying opportunity.

There is a faint, but growing murmuring that having been out of favour for a while, investment grade bonds in particular, could be set for a resurgence.  Such an argument also works if you believe that we have seen the worst of the recent spate of interest rate rises.  The latest inflation data seems to have shown that spending has slowed, and with many people coming out of fixed rate mortgage deals over the next six months, the chances of further cuts in consumer spending are increased.

Let's remember also, that whereas banks were previously prepared to ignore some of the rate rises from the Banks of England (BoE) to remain competitive in the mortgage market; the rate at which the banks lend each other money (3 month LIBOR) is currently at its highest level for many years at around 6.9%.  The effect of this is that the banks will have to pass on higher interest rates to consumers, meaning that the may have just been saved an additional rate rise this year, the job having been done for them by LIBOR (London Interbank Offered Rate).

All of this will be heartening for bond investors and food-for-thought to those worried about their equity and commercial property investments.