Institutional investors still seek yield from corporate bonds following the rally in 2009. But the ‘easy money’ has been made and managers are working harder for returns. Duration risk is a key factor now, reports Nick Fitzpatrick
“We are still seeing large inflows – some from equity investors and some from government bond investors,” says Simon Blundell, senior portfolio manager, credit, at Aviva Investors.
Several data, such as figures from the Investment Management Association, have indicated that corporate bond fund sales to retail investors have slowed since equities bounced back, but institutions continue to fill mandates and search for favourable yields in the corporate bond sector.
Benno Weber, head of fixed income at Swisscanto, a Swiss-based fund management firm, says: “At the beginning of 2009 there were a lot of corporate bond mandates as people tried to cash in on the rally, but these mandates can take time to fill up.”
The rally – pitched as a once in a lifetime opportunity by some commentators – followed the collapse of Lehman Brothers in 2008, which pushed the prices of corporate bonds issued by banks downwards as the market feared large-scale bank defaults. Falling bond prices increases the fixed-interest yield paid out.
The spread, therefore, between bank corporate bond yields and the yield on so-called risk-free government bonds widened. This also extended to other areas of the market as default fears spread. As an indication, average spreads on UK and European BBB-rated bonds soared above 500 basis points.
But these spreads have since narrowed as fears of defaults have receded. So aren’t investors a little late to cash in? Undoubtedly, but managers say there are still good opportunities for yield hunters.
Andrew Wells, chief investment officer of fixed income at Fidelity International, says: “For investors in search of yield, investment grade corporate bonds are likely to remain the key focus [in 2010]. While yields have fallen from their peaks of March this year, yields remain attractive versus cash and government bond alternatives.”
Blundell, at Aviva, says: “Valuations today are less compelling than at the start of 2009, but on an historic basis they are still compelling because the risk-free rate is still low.
“If investors want to increase their overall yield in fixed income then credit is still attractive.”
John Anderson, head of credit at Gartmore, says that in the UK, sterling investment grade corporates were 450 basis points over government gilts at their peak. This spread is now back to 200 basis points. “This is nowhere near the value of last Christmas, but 200 is still higher than the spread has been in most recessions.”
He adds that when spreads reach 120, this will represent fair value.
In Europe, in absolute yield terms, credit yields peaked around 7.5% in October but are around 4% now, according to David Stanley, fixed income portfolio manager at T. Rowe Price, referring to the Barclays Euro Credit Index.
“I doubt that I will ever again in my lifetime see spreads as wide as what they have been,” he says.
T. Rowe Price’s euro-denominated Sicav in the year to end October 2009 returned 24.3% versus an index return of 14.7%. Outperformance came from a multitude of factors, Stanley says, including an overweighting of financial bonds, particularly subordinated issues, an above-index weight in cyclical names, as well as a small allocation to high-yield issuers.
Good support
Stanley believes corporate bonds will find good support from economic conditions. His views are about UK and European credit, but can be broadly applied to the US too.
“We expect a below-trend economic recovery, which has historically been good for credit. While economic contraction is bad for credit, very strong growth has not proved to be ideal, as companies may be tempted to spend more on capital investment, dividends, acquisitions and even buybacks. Our base-case expectation of a tepid recovery is well suited for future credit performance.”
Similarly, Raffaele Bertoni, head of fixed income for Europe & Asia at Pioneer Investments, notes the effect of deleveraging taking place in developed markets and says this should be supportive of corporate bonds too.
“We are clearly in a deleveraging environment and this is usually good for spreads in general because it increases the quality of the company. In a deleveraging period corporate profitability normally suffers but cash flows usually increase, which is good for corporate bonds because it allows companies to repay their debts.”
Default rates, which have been on an upward trend since late 2007 and have accelerated rapidly over the last twelve months, were due to peak in the final quarter of 2009. Citing a Moody’s report Stanley, at T. Rowe Price, says default rates should fall to 5% in 2010, which is also supportive of corporate bonds.
Corporate earnings are beating expectations too – another good pointer. However, for the rally to sustain itself, Stanley says more evidence of sales growth is needed.
“Corporate earnings in the third quarter have been encouraging and generally beating earnings-per-share expectations. However, for the rally to sustain itself, we need to see more evidence of increased end-user demand positively affecting top-line growth.”
Global corporate bond issuance rose to $1.791 trillion (€1.21 trillion) during the first half of 2009, exceeding the prior record of $1.74 trillion in the first six months of 2007, according to Standard & Poor’s. For all of 2008, $2.359 trillion in new corporate bonds were issued.
Blundell, at Aviva, notes that there has been a huge issuance in corporate bonds over the last six months in euros, dollars and sterling. This is taking up the slack from large inflows from investors, but demand is still greater than supply, he says.
Good names
Financials led the corporate bond rally and fund managers believe this sector could still deliver outperformance. However, closer attention to brand names will be necessary in 2010.
Richard Woolnough, a fund manager at M&G Investments, who runs the Optimal Income Fund, has been a successful investor in corporate bonds, having found opportunities in subordinated debt – the debt that a company pays back after other obligations. The subordinated debt of financials was a chief driver of returns in the rally.
Woolnough says that buyers of financials will have to focus more on the quality of the bank in future. “It is not the case of simply buying the market; fundamental and intensive research into the bank you want to invest in is the key.”
Woolnough was vocal about his underweight position in credit risk right from the start of the sub-prime crisis in the summer of 2007. He felt the rapidly deteriorating economy, especially in the housing market, meant banks were set to experience a lot of pain.
However, at the time, deeply subordinated financial debt formed about a quarter of the UK corporate bond market. There was a major risk that these bonds would not be called, says Woolnough, meaning investors might not have received their full principal.
He says: “It is true that returns for deeply subordinated bank debt have been excellent this year, and we have participated in some of that rally. It should be noted, however, that investors that bought deeply subordinated bank bonds back at the start of 2008 are still sitting on a significant loss.
This year, as prices for bank bonds fell, investors began to receive a significant return for taking the risk of investing in these types of bonds.”
He adds: “When we invest in subordinated debt issued by a bank we ask ourselves a number of questions. Is the bank a national champion? Does the bank have good access to capital markets? Has the bank avoided the need for state intervention? We want positive answers here.”
Some bonds M&G has bought include subordinated debt issued by banks such as HSBC, Goldman Sachs, JP Morgan and BNP Paribas.
As well as a tighter focus on issuers, another trend that may well develop in the corporate bond market is that managers will move higher up the finance structure.
Markus Graf, an analyst at S&P Fund Services, says: “Some managers think the market may be at a turning point and have reviewed their riskier assets, including tier 1 bank bonds [the lowest ranked securities in the debt capital structure]. However, most managers remain optimistic on investment grade corporate bonds and many still see the best risk/reward opportunities in selected financials.”
Graf also says managers in the UK agree that the “easy money” has been made and that individual bond selection is more important going forward. “Many managers see limited capital gains in 2010 and expect most performance to come from yield.“
A trickier issue, though, is duration positioning, which in 2010 could be crucial. Most managers think that government bond yields will eventually rise but there is no consensus about the time scale.
Typically, the longer the duration of a bond, then the higher the yield, but uncertainty about when inflation might occur and how bad it will be makes choosing the right bond duration difficult.
Inflation in the UK may result from quantitative easing, whereby the Bank of England has poured money into the economy through asset purchases from banks to free them up to lend money and boost growth.
“No-one knows what is going to happen with quantitative easing at the moment as the exit strategy is difficult to predict,” says Graf.
When the Bank of England purchased government bonds as part of its quantitative easing programme, the purchase kept the yield on these bonds down. Investment managers are concerned about the massive government debt supply, or the funding need. Should gilt yields rise again, it could drive up corporate bond yields too, unless the spreads of corporates over government bonds – the credit spread – narrows further and compensates investors for the rise in yields. Bond prices fall when yields rise.
Credit spreads are now much tighter than earlier in the year and corporate bonds have become more sensitive to changes in government bond yields, known as interest rate risk. Graf says: “Many fund managers are aware of increasing interest rate risks and run a portfolio with a somewhat lower duration.”
Graf warns that interest rate risk is something individual corporate bond investors need to be aware of and probably aren’t.
©2009 Funds Europe
