Investment Briefing: Current opportunities in Bond Markets, December 2011

Recent market conditions present opportunities to long-term bond investors. In this briefing we consider two particular opportunities that we believe are relevant to pension schemes, which are briefly summarised here.

Switching from fixed-interest gilts to corporate bonds

The yields on long-term fixed-interest gilts has fallen sharply in recent months which has resulted in a widening of the ‘credit spread’ (the additional yield offered by corporate bonds over gilts). This represents an opportunity for long-term investors to lock into the additional yield (which currently stands at an additional yield difference of over 2% pa) by switching from fixed-interest gilts to investment grade corporate bonds.

For longer-term investors (those with an investment horizon of at least three years) we consider the current additional yield to be attractive and more than sufficient to offset the slightly higher risk of default of investment grade corporate bonds.

Trustees should be aware that if economic conditions continue to deteriorate or if we enter another financial crisis, gilt yields could fall further and corporate bond yields could rise. For those investors currently making the switch from gilts to corporate bonds, this may lead to lower relative returns (or even negative returns) in the short term.

Switching from fixed-interest gilts to index-linked gilts

As a result of recent developments, trustees of pension schemes that have a significant holding in fixed-interest gilts (but whose liabilities are predominantly linked to RPI inflation) have an opportunity to hedge their inflation exposure at a relatively attractive level.  One way to achieve this would be to sell fixed-interest gilts and buy index-linked gilts.

The expected long term Retail Prices Index (RPI) inflation implied by gilt yields (the difference between the yields on fixed-interest gilts and index-linked gilts) has fallen from around 4% pa at 30 June 2011 to just over 3% pa at 30 November 2011.

Therefore, if one thinks that RPI inflation will be greater than 3% pa over the long term, then buying index-linked gilts rather than fixed-interest gilts at current prices would appear more attractive.

Trustees wishing to consider a switch from fixed-interest to index-linked gilts should also note that index-linked gilts have a longer duration than fixed-interest gilts with similar maturity dates which may mean they provide a better match to a pension scheme’s long-dated liabilities.

Further information

For more detail including charts and background information on the investment opportunities summarised here, please see our full First Briefing on the “Current Opportunities in Bond Markets, December 2011“.

This can be found along with past investment briefings on our website.

The views expressed in this briefing note are based on market conditions at the time of writing. As market conditions change so will the relative attractiveness of the options considered.

This briefing summary should not be construed as investment advice. If you wish to consider its applicability to your particular pension scheme or wish to discuss any aspect of your investment strategy please contact us.

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