Given that low Base rates are here to stay for a long while yet, which assets will benefit most from the BoE’s low-rates-for-yonks policy (which is primarily directed at halting the recession and, as a consequence of growth, reducing unemployment)?

Normally government bonds sell-off (higher yields) when the market sniffs an economic recovery but with so much spare capacity in the economy to be worked through, Base rates will remain low until a recovery is well under way and unemployment has turned decisively lower.  In this environment short-dated government bonds should continue to do well, especially for those within 5 years of maturity.  Longer-dated yields may well go higher (especially once the BoE finishes spending its QE money) with the result that we may see a very steep yield curve sustained for quite some time.

Credit spreads on corporate bonds should carry on tightening, although there will come a limit when the absolute level of the coupon offered scares investors – lending money to a BBB-rated corporate at, say, 3% for 5 years will surely make investors think twice.  The margins currently enjoyed by banks will also serve to stop credit spreads from tightening too far as banks enjoy better protection on their loans (so logically the credit spread on corporate bonds ought to be greater than banks’ lending margins).  A steep yield curve also benefits banks greatly too.

Commodities follow a price path all of their own as they offer no yield, so they offer little attraction to income-seeking investors.

Which brings us to equities. Yields in excess of government bonds coupled with low Base rates until a recovery appears mean that equities could quite easily become over-valued against the current backdrop of macro policy.  Companies with big pension schemes may not join the party as the combination of tightening corporate credit spreads and bond yields being held down by QE buying will result in lower AA-bond yields (which are used as the discount rate with which pension scheme liabilities are calculated).  This will temporarily result in bigger pension scheme deficits which the market may well take fright at (again) for those companies affected (the usual suspects are British Airways, British Telecom, etc.), but the effect will subside once the BoE stops propping up the gilts market and long-dated gilts sell off (higher yields).

Once the supply of fresh equity from companies raising money to pay down debt and get their balance sheets into better shape has largely abated, the coast will be clear to bid up the price of equities.  Any type of a recovery (slow & protracted would be ideal) will result in companies growing their top-line sales revenues, whilst all the cost-cutting implemented since the credit crunch hit in summer 2007 means that lots of that top-line growth will translate into higher profits.  And high unemployment rates also mean that workers won’t be getting much of this profit growth.

The obvious risk to this all-out bullish view is that the economy double-dips badly and the hoped-for GDP growth never materialises.  Until that prospect (which looks very unlikely at the moment) seems much likelier to happen, it will not pay to be bearish on equities.  The Bank of England is too worried about spare capacity bearing down hard on inflation to care much, for the time being, about an asset bubble developing in equities.

Insurers got themselves confused between the subtle difference of writing a diversified portfolio of credit default swaps (essentially a bet that credit spreads were too wide and the future level of defaults would more than compensate the risk taken) and investing in a diversified portfolio of corporate bonds  (also a bet that credit spreads were too wide and the future level of defaults would more than compensate the risk taken).

The reason the comments in brackets are exactly the same is that it is in fact the same bet.  But insurance companies are supposed to take their premium income (customers paying the insurers to shoulder risks) and invest them in financial markets.  Writing credit default swaps, however diversified a spread of risk that is written, is not the business of insurance companies trying to acquire or write premium income.  They should not double-up on their risk but should simply invest their “float” of premium income in such financial assets they deem most attractive at any point in time.

This was essentially the mess AIG got itself into and other insurance companies should steer well away from writing credit default swaps (other insurers have dabbled in the CDS market but none to the extent AIG did).  The end result will be wider credit spreads than otherwise prevailed when AIG was in its CDS writing prime, but these will compensate real-money investors for the risks they take in lending money to companies.

If credit spreads get too wide then eventually investment money will be attracted to the asset class and spreads will tighten, which is how the world is supposed to work.

In the meantime avoid any insurer which writes Credit Default Swaps.

The UK composite insurers (notably PRU & AV) have a business model which combines life assurance, asset management & general insurance. One way of looking at them is to consider them as investment funds with an operating business attached. Their investment funds are stuffed full of government & corporate bonds and have a much smaller percentage of equities than they used to prior to 2000.
As such, given that the BoE is determined to force the price of Gilts higher and corporate credit spreads are still very wide, they are a high-yielding version of a corporate bond fund, selling at a discount to NAV.
Their dividend yields are covered by their largely stable earnings from the existing life assurance book & their earnings from general insurance (rates are hardening in this market due to a scarcity of capital caused by the credit crunch/bear market).
They offer a recovery story with considerable upside and double-digit dividend yields whilst you wait for the recession to play out. Corporate credit spreads will normalise at some point in the future, equities will recover and PRU & AV will once again trade near to their embedded values (which will themselves rise as markets recover).
Solvency and worries about insurers having to raise capital via rights issues (which would lower those NAVs due to new shares being created) are the bear points but in their recent results announcements PRU said they had an IGD solvency surplus of £1.7 bln (and their new CEO is presumably less keen on buying large chunks of AIG than their recently-ousted old CEO Mark Tucker), which would fall by £350 mln if equity markets drop 40% from end-2008 levels.  AV said they had an IGD solvency surplus of £2.0 bln which would be reduced by £800 mln if equity markets fall 40% from end-2008 levels.

Composite insurers are high beta stocks and their share prices will always move faster than the FTSE, however the market has become too bearish on the sustainability of their capital positions.  Although share prices never move in a straight line, their discount to NAV will unwind as confidence returns to financial markets.

A new wholesale bank is born.  The UK Treasury has provided more details about its Asset Purchase Facility (APF), a £50 billion fund, financed by Treasury Bills & managed by the Bank of England, which will buy corporate debt, commercial paper, syndicated loans & asset-backed securities.  The stated objective of the APF is to “increase the availability of corporate credit” by making purchases which “would be most likely to restore the flow of finance to corporate borrowers”.  The plan is to wind down this fund as “normal conditions return”, i.e. when corporate credit spreads have tightened back into historical ranges, mostly by allowing existing assets to mature (rather than pressuring the market with a £50 bln overhang of paper).

The BoE has been directed to publish a quarterly account of the APF’s transactions together with an assessment of developments in corporate debt markets.  These accounts are sure to be eagerly awaited by the market – given that the BoE has been directed to buy “high quality assets”, any company which gains the BoE seal of approval will surely see its credit spreads tighten.  But then again that is the purpose of the APF, to tighten spreads and improve liquidity in the corporate debt market.

Whilst the prime objective is not to make money, the APF most certainly will – pots of it.  With 5-year investment grade corporate debt currently yielding in excess of 6% and Treasury Bills yielding less than 1%, this is going to be a good business for the UK taxpayer to get into (and I can’t see any of the APF’s profits being paid out to BoE employees in bonuses either).  But if this is such a great idea – why didn’t anyone think of it before..?  Well, Citigroup did when they invented the Structured Investment Vehicle (SIV) in 1988.  Like all banks, SIVs borrowed short & lent long (in their case buying bonds financed by issuing commercial paper).

Citigroup’s idea lasted 20 years until August 2007 when worries about losses on SIV’s assets caused commercial paper investors to refuse to lend the SIVs any more money.  Game over.  Whilst all the existing SIVs were closed down or went bankrupt post-August 2007 (Sigma Finance, the last surviving SIV went into liquidation in October 2008), the APF mirrors the idea perfectly.  The APF won’t suffer funding problems because Treasury Bills will always find buyers and any losses the APF suffers will be covered by the Government.  A 5% spread on £50 bln implies profits of £2.5 bln annually (credit losses will be non-existent as any company enjoying access to APF funding is highly unlikely to go bankrupt), the APF will prove to be a source of revenue which the Chancellor is going to be reluctant to shut down.  The SIV is dead, long live the SIV.