Fixed Interest - quarterly commentary from AEGON Asset Management
In the second quarter of 2008 gilt yields rose between 0.29% and 1.4% across the curve. Medium dated bonds returned –4.69%, underperforming both short and long dated bonds, which returned -1.79% and -4.00% respectively. The market as a whole returned -3.61%.
The Bank of England Monetary Policy Committee (MPC) cut base rates once during the quarter by 0.25% in April, reducing the rate to 5%. The evidence of tight credit standards outweighed the concerns over rising inflation pressures at that time. However, the publication of the Quarterly Inflation Report in May had a more hawkish tone. It implied that the MPC’s inflation target might not be reached if rates were cut further. At the start of the quarter, the market had expected rates to fall to 4.75% by the end of the third quarter. Current expectations show rates rising to at least 5.25% by year-end.
The UK government bond market was fairly stable in early April following the volatility seen in the first quarter. The rise in US unemployment to 5.1% and the downbeat picture painted in the Bank of England’s credit conditions survey helped support the market. However, during the remainder of the month yields increased steadily as rising European inflation added to domestic inflation concerns. May began where April left off with yields rising further. Domestic activity data showed an economy stagnating while facing rising price pressures. The rise in manufacturing price data helped trigger a sharp rise in yields. This, coupled with a CPI reading of 3%, prompted more curve flattening with short-dated gilts underperforming again. The dominant themes of inflationary fears outweighing weakening growth continued in June. The closely watched service sector PMI survey fell below 50 for the first time in five years.
For the initial few weeks of the quarter, the credit market was still buoyed by the rescue of Bear Stearns in March. The emergence of the bank recapitalisation story prolonged the post-Bear Stearns rally as it was believed that the equity market was going to ‘solve’ the financial market’s problems with fresh capital. UBS and Lehman Brothers announced equity capital injections, as did AIG in the insurance sector. In the UK, both RBS and HBOS announced forthcoming rights issues.
As the quarter progressed, poor earnings outlooks for banks and the continued decline in asset values caused the strong rally in credit to deteriorate. The recapitalisation thesis was scrutinised by the equity market when the HBOS rights issue price level was tested from a position of around 40% cushion from when the rights issue was announced. Though shareholders voted to accept the rights issue, it still had a negative effect on market sentiment. By month-end, financial spreads widened 20 basis points from the quarter’s tight levels, while non-financial spreads remained extremely anchored.
Investment bank trading desks generally trimmed headcount further and continue to have very little desire, and ability, to take risk onto their balance sheets. For this reason, liquidity remained historically low. A large volume of primary corporate bonds was issued in the second quarter, and this was particularly dominated by banks. For the most part this new issuance was offered at a decent discount to secondary levels and was typically at the more quality end of the issuer spectrum - and generally rallied to meet secondary levels.
Overall, credit outperformed the risk-free rate for the quarter, driven by tightening spreads, particularly in financials, during April and the beginning of May. As we approached quarter-end, financial spreads widened from their 2008 tight levels as the incremental newsflow from the sector and indeed the economy reminded investors that difficult times remain ahead in the capital markets.