As the Bank of England (BoE) continues its fight against inflation and the UK market ponders the likely influence of a Labour government, Insight Investment portfolio manager Damien Hill surveys the shifting UK corporate bond market and wider fixed income landscape.

Key points

• Market forecasts on falling interest rate movements have seen a significant reset, with many financial analysts now predicting only modest rates cuts this year.
• Persistent inflationary pressures and market volatility are helping to create a favourable backdrop for active fixed income investments, including UK corporate bonds.
• Demand for fixed income assets looks set to remain strong in the months ahead, given positive overall yield levels.
   

After widespread predictions of significant rate cuts this year market forecasts on interest rate movements have seen a reset, with many financial analysts now predicting only modest rates cuts this year¹.

For Insight’s Damien Hill, uncertainty over interest rate movements, persistent inflationary pressures and market volatility present a favourable backdrop for fixed income investors.

“In our view, core inflation driven by services and wages is likely to stay more elevated for longer meaning the number of interest rate cuts possible from the major developed market central banks is likely to be less than many market participants were forecasting,” he says.

“We expect demand to remain strong for fixed income in the months ahead, given overall yield levels provide both attractive income and capital gain potential versus other risk assets. In the wider market landscape, we also believe geopolitics - amid numerous national elections in 2024 - will continue to drive volatility, creating wider opportunities for active managers.”

UK election

The UK’s own recent general election offered few surprises after a widely predicted win for the Labour Party was confirmed. Yet others, notably the French and wider European Union elections, have proved more unpredictable.

From a UK fixed income investment standpoint, Hill believes the most value in UK corporate bonds currently lies within the investment grade (IG) sector on a risk adjusted basis. The demand picture for investment grade credit, he adds, appears strong. Hill points out that both institutional and retail investors are attracted by high IG yields that can, in some cases, exceed the dividend yields of their headline equity counterparts.

Within the UK corporate bond sector, Hill believes non-cyclical issuers currently look attractive with utility companies well placed to benefit from any major new renewal of Britain’s ageing infrastructure or renewable energy related projects under Prime Minister Sir Keir Starmer’s Labour government.

“We see a lot of new issuance coming out of the utilities sector. This, in turn, is largely tied to electrification of UK energy networks and the upgrade of archaic infrastructure such as the networks underpinning Britain’s national water distribution. In contrast, while banks and property were investment sectors we favoured for a long time we now believe they are much closer to fair value,” he adds.

From a risk perspective, Hill notes signs of stress in high yield markets, which have prompted a recent shift by some of the weaker UK corporate high yield bond issuers to secure funding from private debt markets. Yet while the resilience of issuer bond documentation is also falling under greater scrutiny he does not expect to see any major uptick in corporate bond defaults.

“While we may see a modest rise in defaults over time, we believe these will be relatively contained and should fall within low single digit percentages. In an historical context we do not expect defaults to hit the highs we saw during the pandemic or global financial crisis,” he adds.

Despite some gloomy market predictions for the UK and Europe versus the US, Hill says he believes there are a lot of technical positives for the corporate bond sector across these markets.

“Yields are rising and there continues to be strong demand and relatively low supply for UK corporate bonds in what is quite a resilient sector.

“More widely, we believe fixed income is a great place to go for income generation. We also expect some capital gains to come through in the months ahead and if we have a much harder economic landing than expected fixed income could compare even more favourably with equities,” he concludes.

The value of investments can fall. Investors may not get back the amount invested. Income from investments may vary and is not guaranteed.

¹Morningstar. Economic Insights. 4 Charts on Plunging Expectations for US Fed Rate Cuts. 11 April 2024.