Where next for the corporate bonds market?

"The rally is reminiscent of Usain Bolt in the 100m at the Beijing Olympics. Historic. Unprecedented. Fast Corporate bonds have been the star performer in financial markets this year." Anthony Doyle, M&G Investments

Hear, hear

The rally in corporate bonds so far in 2009 has been slightly more profitable and is plenty more sustainable than the "melt up" we are seeing in stocks.

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Believe it or not, bonds have actually outperformed the stock market since the beginning of the year. The FTSE 100 has gone up 30% from its low, but is only up 13% from the beginning of the year. Meanwhile, corporate bonds have rallied 17% since 1 January.

However, bonds have been going up so long, some investors are getting vertigo

That brings us to the inevitable question

Is it time to sell bonds?

Think back to when we first flagged up corporate bonds. The case was three-pronged:

Bonds were less volatile than stocks. This is always the case. Bonds are more boring and less risky than stocks. But for once, on top of this, corporate bonds were offering "stock market-like" gains.

Bonds had an active buyer in the Bank of England. The government was on the verge of stepping in to the market and buying through the Bank of England's £125 billion Asset Purchase Facility. The fund was targeting corporate and government bonds.

Bonds were cheap as chips. The relevant valuation measure "spreads" the difference between how much income corporate bonds pay over the amount government low risk bonds pay was at record highs. This means active investors were better off holding corporate debt yielding 7% than government debt yielding 3%.

How do those arguments stack up today?

Even better.

For one, bonds are still less volatile than stocks. But there's more...

You see, bonds still have an active buyer in the Bank. In fact, the Bank of England threw another £50 billion into the quantitative easing pot last week. This is the Bank buying into the bond market to increase liquidity. What it's actually doing is helping to raise prices. Now, this new money will go mainly into gilts government bonds but it will nonetheless proffer some support for corporate bonds.

The only blemish in the argument is that with the rally bonds aren't as cheap as they once were. Bond spreads (the measure of under- or over-valuation) have narrowed sharply from their Armageddon highs reached during the Lehman Brothers induced panic last year.

However, they are still undervalued. M&G research shows that corporate bond spreads reflect a "normal" rather than "historic" recession.

So, these bonds remain a buy.

What would lead us to sell? There's one clear signal you should follow.

When the Bank of England gets "hawkish" in other words, it starts talking about interest rate rises.

You see, the Bank stopping its quantitative easing (QE) program is not a big problem. There is sufficient investor interest in the market now to continue the rally. However, the Bank has a much more powerful weapon against the bond market than QE...

The dangerous return of high interest rates

If the Bank gets hawkish, then all investments that offer a fixed income will suffer. High interest rate environments can be good for property, stocks and commodities, but not bonds. When the rate comes off the 0.5% floor, we should start to worry.

Given that there is only one way for rates to go up our position could change as soon as the next MPC meeting in September. When the hawk is back we will be prepared to reduce our position in corporate bonds. For the time being, they are still the halfway house between safe but low yielding government bonds and cyclical but riskier stocks.

Corporate bonds may not be a screaming buy anymore, but there is still plenty of "recession protection" embedded in the current valuation. As long as the Bank of England is buying and interest rates are low, the outlook for corporate bonds will continue to be rosy.

Since we first talked about the M&G corporate bond fund on 4 March 09, it's up 13.6%. And it could have further to go. Until interest rates start going up, the conditions continue to favour this type of investment.

This article was written by Theo Casey, investment director of the Fleet Street Letter , and was first published in the free daily investment email The Right Side on 12 August 2009.