Fixed interest

July 2010 (covering the month of June 2010)

Fixed interest markets remained unsettled leading to further risk aversion and a rally in better-quality government bonds. There was further weakness in peripheral Eurozone sovereign debt as Greece was downgraded four notches to junk status by Moody's. Despite the downgrade, Moody's said that the outlook on Greece's rating is now stable and that the risk of Greece defaulting on its debt is low. Uncertainty surrounding the July 1 expiry of the European Central Bank’s (ECB) €442bn one-year loan facility for banks added further tension. However, news that banks borrowed only €132bn at 1% on the final day of June from the ECB’s replacement three-month facility was seen as positive. Elsewhere, there were mixed results at government bond auctions, with Spain’s oversubscribed and Italy’s undersubscribed. Over the month yields on two-year Greek, Spanish and Italian bonds rose by 279bps, 54bps and 11bps, respectively. In contrast, yields on two-year gilts fell by 14bps while the US 2-year yield fell by 16bps and reached a record low of 0.59%.

Investment-grade bonds saw positive returns, despite some modest spread widening. According to data from Merrill Lynch, sterling BBB rated spreads increased by 18bps for a 0.7% gain. Spreads on sterling tier 1 bank debt widened by 29bps for a 0.4% again, however euro tier 1 bank debt fell 4.3% (in sterling terms). European high-yield spreads narrowed by 20bps and although euro returns were flat, returns were -3.1% for sterling investors. Moody’s reported that the European high-yield default rate fell to 6.8% in May from 7.8% in April, down from the November 2009 peak of 11.8%.

The UK’s Monetary Policy Committee voted to keep interest rates unchanged at 0.5%. However, the minutes caused a surprise by revealing a 7-1 split in the vote after Andrew Sentence voted for a 25bp hike in the rate - the first vote for a hike seen since August 2008 - although the decision to keep asset purchases held at £200bn was unanimous. The Committee’s central view remains that the substantial margin of spare capacity is likely to persist for some time and cause inflation to fall back in the medium term. The meeting took place ahead of the emergency Budget which saw aggressive spending cuts outlined by the Chancellor as well as an increase in VAT to 20%. As a result, general government gross debt is projected to peak at 85.5% in 2012-13, below the 100% level that Standard & Poor’s cited would jeopardise the UK’s AAA rating. Planned gilt sales for the current fiscal year were also cut by £20bn, to £165bn. Annual UK CPI inflation was reported to have decreased to 3.4% in May, from 3.7% in April. The RPI measure also fell, from 5.3% to 5.1%. Downward contributions came from food prices and petrol prices rising at a slower rate than a year ago.

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