Rays of hope for bonds?

For some time there has been concern about the absolute levels of interest rates in the gilts market and the narrowness of spreads in the corporate bond sector.

It has also been clear for some time that a correction was warranted, given the prevailing rate of inflation and the benign level of growth in the UK economy.

The real issue for the New Star bond fund managers has been the timing of the market decline, and so, for some months, they have been pursuing a defensive stance.

The first phase in a re-evaluation of the gilts market came in February; this was followed in March by a corresponding shift down in the price of corporate bonds.

For some while, the economic data has been mixed. Manufacturing output and retail sales were weak in January, although the consumer continues to show signs of life. The housing market remains on a good footing, with prices in most regions still rising, albeit at a slower pace than in recent years. Fourth quarter gross domestic product came in above forecast, at 0.7%.

None of this seemed to disturb the market. During February, however, a number of worries began to preoccupy investors.

The Bank of England's Quarterly Inflation Report was not as bearish as had been forecast.

Interest rates were held at 4.75%, but when the minutes of February's Monetary Policy Committee meeting were released later in the month, the surprise was that Paul Tucker, one of the members, had actually voted for a rate rise.

March's meeting again held rates, but this time with a second committee member voting for an interest rate increase. The minutes of the meeting revealed that members differed on the amount of evidence needed to justify a rise in rates, suggesting that the peak in short-term rates has yet to be reached.

The Budget contained very little of substance, with one exception: the UK, like the French Government, is to issue a new 50-year gilt. The gilts market, which had fallen sharply during February, remained nervous, with the long end of the market underperforming.

Although the gilts market had achieved some stability by the end of the month, the corporate bond market suffered dramatically during March. Investors appeared reluctant to take more corporates on board, prompting spreads to drift wider.

This turned into a sharper correction following a number of disappointing developments, notably General Motors' profit warning, bringing the company ever closer to a downgrade to junk status, thereby distorting both the investment grade and sub-investment grade bond indices.

The American insurance giant AIG lost its S&P AAA credit rating following the announcement of required adjustments to their financial statements, and a pick-up in merger activity reminded investors of the risk to credit ratings in leveraged buyouts.

The yield premium on the Barclays Non-Gilt All Maturities Index widened by eight basis points in March, the biggest deterioration in spread since July 2002.

Issuance of a blockbuster 50-year Euro Telecom Italia deal has further shaken the investment community, and high-yield bond spreads widened by 69 basis points on the month - a shocking move for many professionals.

New Star's fixed interest team are in an interesting position. They are loath to take an aggressive interest rate position when real yields (nominal gilts yields less the RPIX measure of inflation) are below 3%.

In February, however, the annualised RPIX figure came in at a surprisingly low 2.1% and in March long gilts were hovering in the region of 4.6% to 4.7%. This suggests that they are much closer to fair value now than for many months.

Moreover, the dramatic sell-off in corporate bonds means that there is very good value to be had, and there is considerable supply as dealers try to clear up their positions.

Probably the tide has just begun to turn as far as values are concerned and the team is not far off taking a much more constructive stance where interest rates and credit are concerned.

The prospects for bond markets are looking more reasonable than they have for some time. For some time there has been concern about the absolute levels of interest rates in the gilts market and the narrowness of spreads in the corporate bond sector.

It has also been clear for some time that a correction was warranted, given the prevailing rate of inflation and the benign level of growth in the UK economy.

Phil Roantree and Theodora Zemek are fund managers at New Star Asset Management. Ms Zemek is the fund manager of the New Star Strategic Government Bond Fund, which is listed on the Malta Stock Exchange and is represented in Malta by Jesmond Mizzi Financial Services Limited, which is licensed by the Malta Financial Services Authority. Further information can be obtained from FMFS at 67/3, South Street, Valletta, tel:2122-4410 or e-mail: info@jmfs.net.