Governor of the Bank of England (BoE) Mervyn King yesterday delivered a seminal speech, detailing what has gone wrong with the global economy, stating that despite recent interest rate cuts there remains a risk that inflation will fall below 2% (thus implying further rate cuts), and exploring both conventional and unconventional policy responses.

King explained that conventional policy responses (such as those tried in Japan) include the buying of government bonds. He explicitly stated that ‘at some point’ the BoE would consider buying corporate bonds, explaining that credit spreads are twice as high as in September, and the BoE estimates that a significant portion of this spread is an illiquidity premium. Purchasing corporate bonds would remove some of this illiquidity premium and thereby raise the value of assets that are currently under priced. The BoE’s actions would encourage companies to issue bonds, improve trading activity and reduce companies’ reliance on bank lending. Crucially, he suggested that the Monetary Policy Committee may adopt such measures as an instrument of monetary policy. More details will be announced at the end of January.

As corporate bond investors, we want to understand what assets the Bank of England will buy, and buy them first. King provided a few clues. The BoE wants to provide temporary liquidity – it does not want to artificially support markets for which there is no underlying demand. Any intervention would be directed only towards markets which normally play major roles in the functioning of the financial system. And, very importantly, the BoE will consider buying ‘only high quality assets’ – it wants to avoid taking much more credit risk onto the public sector balance sheet.

 

We can assume, therefore, that the BoE will only purchase investment grade corporate bonds. We would expect purchases to be made in industrial companies. It is also conceivable that purchases will be made in senior bank bonds. We can also be reasonably confident that it will not be purchasing deeply subordinated bank bonds, which carry lower credit ratings (RBS Tier 1 bank bonds were downgraded to high yield status on Monday, for example). Asset-backed and mortgage-backed securities are already being purchased under a different scheme, so it also seems unlikely that these will be included.

 

We believe we are very well positioned to benefit from any programme of buying corporate bonds, if indeed the BoE decides to implement this policy action.  M&G’s and Invesco Perpetual’s corporate bond funds have long had a large exposure to industrial investment grade corporate bonds, and where they have bank exposure, they hold more senior bank bonds.  Both these funds are used within our asset allocations.  If you would like to check these, please click here .

This should prove good news to those of our clients with a fixed interest element to their portfolios and confirms the thoughts in our December valuation report.  We continue to recommend corporate bonds over cash.