6th Aug

Going up. Or Down. The Paradox of the ‘Bond Bubble’.

There was a record exodus from bond funds in June after the US Federal Reserve spooked investors in corporate bonds by announcing its intention to reduce its commitment to Quantitative Easing (QE). 

In this article Mr Bond considers the potential for a similar sell off if the UK Monetary Policy Committee was to echo this decision, and weighs it against encouraging signs that the LSE’s ORB exchange is starting to deliver the retail investor base and secondary market liquidity that it was designed to do.

A month into the job as Governor of the Bank of England, Mark Carney’s continued commitment to QE has commentators nervously eyeing the current high valuation and low yields of corporate bonds and questioning whether the so called ‘bond bubble’ is set to burst or continue to soar. 

The low interest environment has seen investors clamouring for the comparatively high returns and relative security of corporate debt, particularly as £375 billion of QE has driven gilt prices up and yields to lows not seen since the 1890s. 

Bears Fearful of Sell-Off

So, following three years of stellar performance, there is only one way for bonds to go then? 

Not necessarily, bears fear that when interest rates rise and existing bond yields look less attractive, investors will shun them and prices will plummet; however, Retail Bond Expert questions whether investor appetite for guaranteed returns and relative security coupled with demand for alternative sources of funding from UK PLC will see the sector remain strong. 

Certainly things appear finely balanced – investors seeking higher rates of return than cash have had to accept a level of risk with which they may not be comfortable, and the slightest whiff of a change in fiscal policy could see them rushing for the exits. 

Mr Carney need look no further than the record £624 million sell off in bond funds in June following Federal Reserve Board Chairman Ben Bernanke’s announcement of a winding down of its monetary stimulus programme, to see the potential implications of the decisions he faces; ‘Investors Rush to Dump Bonds’ thundered the Sunday Times on 4th August. 

".... Despite the fact that the number of retail bond issues in 2013 has been at the low end of expectation, prudent investors can still benefit from a listed investment at an attractive rate of return, and with improved liquidity in the secondary market"

Following years of gains, the value of some bond funds declined 3.5% over the last three months, and began to recover only when the Fed confirmed that the tapering of the stimulus would not begin until the US recovery was firmly established. 

So what does this mean for retail bonds? Base rate has been hanging at 0.5% since March 2008 and cash savings rates aren't much higher. Despite the fact that the number of retail bond issues in 2013 has been at the low end of expectation, prudent investors can still benefit from a listed investment at an attractive rate of return, and with improved liquidity in the secondary market. 

Whilst considered inappropriate for the majority of retail investors, the unlisted ‘mini-bond’ market, as identified by business group Capita, also looks set to soar to £1 billion this year and £8 billion in the next five years as investors pour their money into them. 

Transparent Information

Retail Bond Expert campaigns for comprehensive and transparent information in support of retail bond issues, and supports the initiative of issuer group ORBIG to establish a ‘traffic light’ rating system to allow the objective comparison of products. 

This site seeks to provide sufficient education and information to allow an individual to make an informed investment decision, but as ever Mr Bond recommends that professional advice is sought if the slightest uncertainty exists. 

Patrick Connolly at Chase de Vere warns against assuming the health of a company's balance sheet. "We have seen how even supposedly strong and secure companies, such as the high street banks, can get into financial difficulties and so you must understand the risks of relying on just one company to pay you," he said. 

Jason Witcombe of Evolve Financial Planning warns against ignoring potential capital gain in pursuit of a headline yield, and highlights the fact that with higher reward comes the higher risk of default. Witcombe also cautions that those wishing to sell a retail bond before maturity may achieve a lower price than they originally paid, although a recent survey conducted by researcher Hardman and Co, suggests that improved retail trading volumes may be improving this situation. 

In its first report into the retail bond market Hardman has identified a large increase in retail bond transactions on ORB over the last two years. 

Fears that liquidity in the secondary market was being stymied by large buy-and-hold institutional investments appear to be abating as the total number of monthly trades has increased from 1,400 to 8,000 over the period, with an average bargain falling from £289k to £55k. 

Encouraging Trends

Not quite ‘tell Sid’ yet, but an encouraging trend, and every indication is that ORB is beginning to deliver the retail participation that it promised at launch with increased trading volumes and an average of £4 million traded in each issue per month. 

Interestingly, Hardman calculates that while ORB-issued bonds make up only a third of the total bonds available on the market, they account for two thirds of all trades. 

Mr Bond says... "Bonds have also offered another way to buy into asset-rich companies whose shares are tightly held."

Better marketing to retail investors has played a role, but bonds have also offered another way to buy into asset-rich companies whose shares are tightly held. For example, trading in the Primary Health Properties 5.375 per cent bond averages over £5m per month, while the Lloyds 5.375 per cent barely manages £650,000. 

However, Hardman reckons there has been a general "levelling up" of liquidity for all bonds quoted on the market and increased retail participation and secondary market liquidity indicate that overall the market will hopefully prove resilient in the face of unwelcome news from Threadneedle Street.   

So, will the market continue to soar, or will the bubble burst? 

If he could answer that definitively, Mr Bond would be doing so from his Sunseeker clutching something shaken not stirred. However, what is for sure, a wily investor should part with his hard-earned only when in possession of all the facts, aware of all of the associated risks and within a balanced portfolio that spreads the inherent risks that exist in any investment.  

As Mr Carney gets to grips with the Old Lady and wrestles with the economic challenges ahead, as ever Retail Bond Expert welcomes your thoughts, comments and contributions.          

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