The Audacity of Desperation

Fixed Interest Update from Hendersons - March 09

The UK authorities have, in recent weeks, announced a raft of policy responses to the current banking and economic crisis. These initiatives have been audacious, both in their scale and the sheer speed of implementation.

The Gilt market rallied strongly on the announcement last week that the Bank of England had decided to pursue quantitative easing through asset purchases of up to £150bn. Up to £50bn is potentially available to buy credit, leaving at least £100bn available to purchase gilts. Estimates as to the size of the quantitative easing prior to last week's announcement had put the figure at roughly £100bn, so the size of the facility surprised to the upside.

The reaction to the news from the Gilt market was rapid and sizeable, with the ten-year Gilt experiencing the largest one day rally since the Bank of England was granted independence in 1997. In effect, the positive price impact of government purchases of Gilts completely overwhelmed any lingering concerns about the long-term inflationary impact of expanding the money supply.

The UK is now at the forefront of central banks in pursuing unconventional monetary policy (albeit Japan was the precedent-setter back in 2001). Yet, as we sit here today, the ultimate impact of this policy is far from clear. Its success in attempting to stimulate the banking system to expand the level of broad money by lending to the private sector will be heavily dependent upon the degree to which the banks decide to hoard the extra cash they have raised by selling Gilts, or actually lend this cash on.

 
Entering the world of 'either/or'

For sterling fixed income investors, it is difficult to overstate the importance that the success of this rather esoteric policy will have as a key driver of returns in the coming years. Indeed, the risks are binary. If the Bank of England is ultimately successful in reflating the economy, they will have to withdraw the unconventional stimulus of purchasing Gilts, at the same time that inflation is beginning to pick up. This would be fertile ground for a rapid sell-off in the government bond market. However if, in the medium term, the deflationary consequences of financial de-leveraging continue to win out, government bonds will remain a safe haven asset class for many years to come.

The inflationary scenario may well be the least-worst outcome for the economy as a whole, but for fixed income investors the potential erosion of capital in this scenario is a worrisome prospect.

It is not simply the government bond market which is presenting bond investors with a binary outlook. The bifurcation of financial and industrial bonds in the investment grade market is equally troubling, not least because the financial sector comprises over 30% of the sterling investment grade market.

The consequence of continued financial sector weakness

The financial sector has dramatically underperformed industrial bonds, and this is most evident in the case of subordinated (Tier 1 and Tier 2) banking and insurance bonds. Investors appear unwilling to assume risk in this sector of the market almost regardless of price, with the consequence that subordinated insurance and banking bonds trading at 10-40p in the pound is now a common feature of the market.

The lack of willingness to assume the risk of these bonds reflects the degree of government involvement in the sector and the lack of comfort that investors have in analysing how politicians may choose to treat bondholders in the future. To date the UK government has been supportive of bondholders in those institutions, which are deemed to have systemic risks attached and need assistance (RBS and Lloyds); injecting ordinary equity as a loss-absorbing cushion below existing bondsand insuring away large parts of risk-weighted assets. However, whilst policymakers have been demonstrating commitment, the lack of a clear framework for treating bondholders (as seen with Northern Rock and Bradford & Bingley) has effectively shut the bond markets as a source of capital for banks, for the time being at least.

The fate of credit markets therefore remain inextricably linked to the financial sector. Until confidence is restored investors will remain wary of assuming risk in other areas of the credit markets. In recent weeks we have seen new issue markets for industrial companies show signs of saturation. Investors' nerves are frayed and there are signs that industrial spreads may follow financial spreads higher in the short-term, despite offering compelling value over the medium and long-term. This is not the convergence that investors were hoping for.

What is clear for fixed income investors overall is that the coming months and years will present some enormous challenges for managing portfolio risks. Flexibility will be vital in order to be able to hedge away risks at the correct time. Within the Henderson Strategic Bond Fund we have used credit default swaps to insure against default risk in credit markets with success over the last 15 months. There will be a moment at which interest rate futures will also be used to hedge out the risk of a government bond sell off. Although it may be premature to think about the latter risk when Gilts have rallied so aggressively, strategic bond fund management requires active management and, as such, at a time when the risks for bond portfolios appear so binary, we remain in a state of perpetual alertness.

By Jenna Barnard, 11 March 2009

Paul Momirovski
Sales Executive
Henderson Global Investors

Compliance check by James Pearcy-Caldwell
Director

Notes …

* This newsletter has been prepared with all possible care to ensure its accuracy. It is based on our current understanding of legislation and HMRC practice. 
* Neither Aisa Direct Ltd nor any of its employees can accept responsibility for any errors or omissions. You should seek further professional advice prior to action.