The sudden halt in the downward trend in UK interest rates has had a dramatic effect on the domestic bond market.

Edward Menashy, chief economist at Charles Stanley, notes, ‘The Bank of England, has conditioned the markets to expect no change in base rates, possibly until the end of the year. The recent sharp decline in some commodity prices holds out the hope that runaway inflation will be contained, even though the phase of maximum pressure is still in the pipeline.’

He adds, ‘Renewed banking concerns, widening credit spreads and persistent high LIBOR rates have elevated the UK gilt market to a safe haven from falling equities. Hence, for those seeking a sanctuary from high volatility in equities, we’d recommend four per cent Treasury 2016 and 2.5 per cent Index-Linked 2013.’

Peter O’Connor of fund of funds specialist IMS feels, ‘Charting a course for effective economic policy is increasingly difficult. We maintain a defensive position. We are underweight equities and fixed income, overweight cash and absolute return strategies. Fixed interest markets remain schizophrenically poised between quality and the longer-term value now appearing in some corporate credits.’

He adds, ‘There is no consensus as to the direction of short-term interest rates, apart from the Eurozone. We have recommended index-linked securities for some time. We remain neutral for emerging market debt. The currencies have performed well but the future, given the current inflationary environment, looks uncertain.’

However, Paul Causer, co-head of the fixed income team at Invesco Perpetual, sees opportunities in the current turmoil: ‘Despite some retrenchment in recent weeks, credit markets have rallied sharply since mid-March. The rescue of Bear Stearns marked the nadir of at least the first phase of the credit crunch.’

Causer says, ‘We still consider high-yield markets to offer compelling value over the medium term. Investors should expect further volatile conditions. Banks have to deliver, loan growth is likely to slow, the macroeconomic picture has deteriorated and the default rate is likely to rise. Nonetheless, credit markets, and banks in particular, are offering good value for investors and we have started to reshape the IP Monthly Income Plus Fund from its relatively defensive stance to one which is seeking to make gains.’

Defensive positions
Looking at the corporate bond market, Chris Palmer, manager of the Old Mutual Dynamic Bond Fund argues that well-established companies with conservative growth expectations will prove to be best insulated in the current climate:‘First-quarter results gave an indication of earnings differentiation between those companies with a mature business focus and those with a more speculative growth profile. I expect the economy
to deteriorate further, leading to lower interest rates by the end of the year.’

Which means prospects for corporate bonds remain attractive, particularly in the financial sector. Palmer says, ‘Balance sheet contraction within the banking sector will lead to lower earnings, but it will reduce financial leverage and thus improve credit metrics. Large-scale capital raising by banks is good for their credit, but bad for their share price. Volatility will remain a feature of the bond markets for the foreseeable future but we expect to see good opportunities to invest in better credits whilst equity prices will continue to be depressed by falling earnings.’