EUROPE - A move by the Bank of England to buy corporate bond debt could be enough to kick start liquidity in the sector again but there are now concerns about the huge investor interest in the sector, claim officials at Standard Life Investments (SLI).

Andrew Sutherland, head of credit at SLI, said the asset management firm believes a decision by the UK's central bank to buy corporate bonds - as suggested by its governor Mervyn King last week - might be the start needed to revitalise liquidity in the capital markets.

More specifically, the BoE is thought to be considering investing £50bn (€55bn) over the coming weeks in "only high quality" corporate bond debt, as officials believe this would reignite trading and the subsequent liquidity needed in the fixed income market to encourage lending again.

That said, the corporate bonds market has seen heightened investor interest over recent weeks as many asset management firms are now advising all investors, including, pension funds that corporate debt is trading with premium spreads compared with the income-generating returns they currently offer in comparison to government and inflation-linked bonds, and Sutherland is concerned investors may dive into the market when problems could still surface.

"We are a wee bit concerned about the hype around corporate bonds," said Sutherland. "There are areas people should be a little more cautious about. It does represent an interesting income opportunity there is no doubt, but there are a lot of problems that are going to keep this risk premium spreads high for a while. We would caution investors' expectations at the moment," he continued.

He noted the spreads on corporate bonds are approximately 3.5-4% higher than government bonds at present, though in many cases according to SLI there is little reason for spreads to be so wide as many bond issuers appear to have strong financial positions compared with banking sector, which has largely driven sentiment in trading over recent months.

"As long as there is pressure to unwind, we will see corporate bonds stay high," said Sutherland. "Investors now feel whereas they would have bought a bond and offloaded in a few years' time, they feel they have to hold it to the end. The Sterling index is worth £400bn."

He later continued: "Many pension funds are looking to rebalance to corporate bond level. Tending to benefit from equities, perhaps because we have taken a more cautious view and financials have bee less risky. Long-dated spreads are pretty attractive, especially long-dated senior bank paper.

He believes a Bank of England move to buy senior and Tier 1 debt would be a strong signal to the market of its confidence in the companies it invests in, as he does not believe the UK government would invest unless it was certain interest coupons were going to be paid.

"We are very supportive of what the government is doing in the banking sector, but a problem going forward is they need to motivate the lending structure.
We have suggested that we think that would a good idea[ to buy corporate bonds]. They wouldn't need to buy every bond in Tier 1 issues, they just need to buy a basket. It would be a strong statement to make because it would say we are confident they are going to make the coupon payments."

He continued: "It is a very small cost for the government to support that sector, rather than let it go [under], which would create more problems for them. If the Bank of England was buying these [bonds] we have implicit evidence to say those calls are going to be met. You don't need to buy the whole upper Tier 2, you just need to buy a portfolio and that would be a signal to the market."

The Bank of England has indicated it will buy its own government bonds if deemed necessary, which in itself create a stir, said Sutherland, as the Bank of England is the only central bank within the European Union membership to be allowed to buy its own bonds thanks to an exemption from the Maastricht Treaty which made it illegal to do so.

Whereas many banking stocks and bonds may be on the black lists of investors, SLI does believe while investors need to select fixed income investments carefully, there are gains to be had from investing in senior financial and telecoms bonds.

"We are getting gilts + 2-2.5% for banks, which is very generous. And we are looking at senior financials and telecoms because they have spreads of 400bps and over, but you do not need to be too risky.

"But defaults are going to rise, particularly in high yield market. Spreads may have peaked for investment grade generally. They provide a good fixed interest hedge, but when gilts start to rise we may see capital gains," he added.