Corporate bonds “area of most concern”

Risk1Investors are facing significant corporate bond liquidity risk and may eventually need an alternative, even cash, an analyst warns.

Andy Brunner, investment strategist at Morningstar OBSR, appears to suggest he is one of few commentators warning about the risk in corporate bonds.

"As yet, few commentators have turned against corporate bonds and for many, where spreads have tightened to levels below previous year-end forecasts, they have simply revised them lower."

The risk stems from reduced liquidity in what is an over-crowded trade.

Nearly all institutional and retail investors are betting on the European periphery in their hunt for yield despite tightening spreads which may not be compensating them enough for the risk. Meanwhile, in the US turnover in high-yield bond markets is less than half what it was in 2007, even though issuance has continued to be high, and investment banks have run down inventories.

"On a six-month view, credit will likely continue to outperform, led by riskier corporates but, the tighter corporate bond spreads become, the risk relative to government bonds also increases," says Brunner.

"From an asset allocation perspective, corporate bonds are perhaps one of the areas of most concern; market participants are hugely overweight an asset where the potential for excess returns has declined significantly and where liquidity is a major issue."

Potentially exacerbating this is the fact that corporate bonds are not exchange-traded and instead are traded over the counter between professionals.

"For now, fundamentals just about stack up – but watch re-leveraging – as they probably appeared to back in 2006-07. An alternative will eventually be needed and it may even be cash."

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