I have seen most things in my three decades in the financial services industry, but I could not have foreseen an environment like this 18 months ago.
Stubbornly high inflation figures mean we are now expecting interest rates of almost 6 per cent in the UK, something that anyone under the age of 30 will not have experienced during their working careers.
It has also changed the dynamics of markets — high-growth companies are no longer the “go-to solution” for investors as they were in the days of quantitative easing and, all of a sudden, UK corporate bonds are starting to look a sensible choice to navigate the continued uncertainty in markets.
Figures from the Investment Association show the Sterling Corporate Bond sector has seen almost £1bn of net inflows in the first four months of 2023, a sharp contrast from the outflows seen in recent years.
For clarity, the yield on a corporate bond fund is made up of two parts: the risk-free rate (that is, gilts) and the spread (the difference in yield between the corporate bond yield and the risk-free rate on government bonds). Spreads are historically attractive on fixed income, but not at the levels we saw on the back of the global financial crisis or Covid-19 when interest rates were at record lows.
At the time of writing, the two-year gilt stands at just over 5.2 per cent, so you should be looking for around 7 per cent from a UK corporate bond (2 per cent above the risk-free rate).
This is a rare environment for the sector for a number of reasons. Not only is it unusual to see both elements — the gilt yield and the spread — so high, but as Artemis Corporate Bond fund manager Stephen Snowden points out, the sector incurred severe losses in 2022, the worst in 40 years of recorded data.
Not only is the income as healthy as you could ask for, but the risk is lower than it used to be. The bond market is full of bonds issued during the QE era, with lower coupons and the prevailing yield offered today.
Snowden says the average price of a bond in the sterling corporate bond market today is 87p in the pound. Essentially, for every £100 claim on a company you are paying £87 on average across the sector.
There are dangers
I agree investment-grade bonds look attractive, but it is far from a bombproof option given the growing threat of recession. While I am bit calmer over the energy concerns, every day that passes with rates and inflation at these levels poses significant threats to the housing market.
The stress is only starting to come through as people come off fixed-term deals and are faced with significant increases in their mortgage repayments in this rising rate environment. One million UK mortgage holders could see their disposable income fall by 20 per cent because of rising rates, according to the Institute for Fiscal Studies.
