05/10/2007

Risks & Opportunities In Corporate Bonds

A significant improvement in banking transparency and liquidity in money markets is required before credit markets can make significant progress, according to analysis published today by leading investment house, Standard Life Investments.

In the latest edition of Global Outlook, its quarterly investment view, Standard Life Investments examines the corporate bond markets, assesses where value lies after this summer's problems, and outlines its current strategy in corporate bonds.

Andrew Sutherland, Head of Credit, Fixed Interest at Standard Life Investments, said:

“This summer's shocks to the corporate bond market were not a surprise, as this was an issue we had warned about for some time. We believe we are in the middle of a period of de-leveraging of risk across asset classes after several years of overly generous credit conditions. We expect trading conditions will eventually return to these markets, through a slow work out of the issues aided by central banks and regulators. Given the robust nature of the global economy, we are confident this unwinding process will eventually be absorbed successfully. While an entrenched global recession involving a period of much higher corporate bond defaults would damage the credit markets, we see the probability as relatively low.

“Using our Focus on Change investment approach, we have identified a number of key triggers which we will analyse in coming months. These include: a financial institution going bankrupt leading to a major crisis; an extended credit crunch leading the US into recession; an extended standstill in the asset backed securities or commercial paper markets; earnings reports from investment and commercial banks and the degree of transparency about their debt holdings; and further action by central banks to inject liquidity into wholesale money markets, including any further interest rate cuts

“Our analysis about the dangers of various strategies in credit markets meant that our corporate bond funds have been protected in the recent difficult times. Our funds are not exposed to bonds backed by sub-prime mortgages. We do hold Heavy positions in certain asset backed securities, but collateral is generally in the form of pubs, hospitals and prime UK mortgages. Where we own high yield bonds, these constitute a small part of overall portfolios and we have used the I-traxx crossover index to hedge in some portfolios. We began to reduce overall levels of risk in our credit portfolios in July when it became clear that this bout of risk aversion would be relatively long lasting.

“Looking ahead, investment grade bonds will continue to see volatility as a result of the current banking crisis and the lack of market liquidity. Spreads look historically attractive – they are at levels last seen in 1998 and 2002, when there were large scale defaults and corporate fundamentals were not as good as they are now. While investment grade spreads represent good value, we need to see a significant improvement in banking transparency and liquidity in money markets before credit markets can make significant progress. High yield spreads are also about fair value but will remain vulnerable to the success of investment banks in reducing their $350bn debt pipeline and a major rise in defaults.

“On balance we are cautiously optimistic about the financial sector; markets are pricing in a scenario for the banks which we regard as too pessimistic. Corporates have out-performed but will be tested when they resume issuance to finance capital spending and any M&A activity. The main risk to this view would be if the liquidity problems in short term money markets affect the banking sector for a period of months rather than weeks.”

Notes To Editors

•  With assets under management of £140.6billion Standard Life Investments is one of the UK's major investment houses and controls around 1.9% of the UK stock market (30.06.07).

•  Standard Life Investments was launched as an investment management company in 1998. It is a wholly owned subsidiary of Standard Life Investments (Holdings) Limited, which in turn is a wholly owned subsidiary of Standard Life plc.

•  Standard Life Investments operates in the UK, Canada, Ireland, Hong Kong and the USA, and has representative offices in Germany, France, South Korea and Beijing. Standard Life Investments also operates in India through a joint venture, HDFC AMC.