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A closer look at the fixed interest market

With interest rates rising in the UK and the US and oil prices soaring to over $70 per barrel, it could be time to focus on the fixed interest market.

Global energy prices have been driven up by the Lebanon and crises, while investors are still concerned over US interest rates and economic growth - all of which has generated volatility in stock markets.

Baring Asset Management [Report] predicts that US growth will slow over the latter part of 2006 but expects interest rates to remain fixed after 17 months of consecutive rises before. As such, it thinks US bonds are an attractive option "and at least offer some hedge against a sharp deceleration in US activity". However, it thinks there is little of interest in the government and corporate bond markets overall.

SWIP [Report] suggests that investment in the bond market may be wise. It expects tighter monetary policy to slow global growth in 2007, before a possible recovery in 2008. It also [Report] thinks US interest rates have peaked, although it expects further rises in the eurozone and Japan. It expects a decline in corporate profits following five years of strong growth, fuelled by buoyant demand, strong productivity, low interest rate costs and muted wage growth. However, this is likely to change due to rising interest costs and slowing productivity, and consequently confidence in the corporate sector will fade and investment weaken.

Meanwhile, New Star [Report] reports that July was a good month for bonds due to a slowdown in US economic growth, with UK gilts returning 1.27 per cent and emerging market bonds gaining 3.70 per cent in US dollar terms.

Standard Life Investments [Report] says that present levels of bond yields are attractive to investors, arguing that it is better for US bonds than US equities in the year after a peak in interest rates - which is widely considered to have just happened.

However, it expects European bond markets to come under pressure in the short-term due to possible improvement in domestic production, and also views the Japanese bond market unfavourably despite a strong performance in the second quarter on the back of weakness in the equity market.

Regarding the UK gilt market, the long end of the yield curve is more attractive for investors, but the short end of the curve also offers investment opportunities, according to Standard Life Investments.

However, it is more enthusiastic about the prospects of index linked bond markets, on the back of investors' concerns about inflation and future economic activity. Such concerns, Standard Life says, are fuelled in the US by the effects of rising interest rates on the economy, a deceleration in the housing market and signs of a slowdown in consumer activity; and in Europe by high levels of consumer debt. As such, index linked bond markets are benefiting from these concerns, although "talk of a recession is most definitely premature".

In addition, UK long bonds are being carried by pension fund demand. Pension fund deficits are often significant relative to the size of the companies themselves, so "liability matching with bonds and inflation linked bonds will become of primary importance". This is despite the net positive performances of both equity and corporate bond markets over the last year, which has taken some of the pressure off pension fund transitions from equities into bonds.

To summarise, fund managers are recommending a cautious glance at the fixed interest market, especially the US bond market. However, European and Japanese bonds are not favoured, while corporate bonds are preferred over gilts in the UK bond market, with the economy remaining buoyant.