April 2009

CORPORATE BONDS: what the eye doesn't see

Corporate bonds may not be the most glamorous or high-profile of investments, but their issuance is currently reaching record levels. Nick Fitzpatrick finds that they are a good asset for long-term investors... londonscene.jpgLondon has inspired many poets and artists over the years, yet the capital’s frenetic trends and shifting skyline can be just as inspiring to fund managers. Within the city’s garbled industrial arena, Tatjana Greil, portfolio manager at high-yield bond firm Muzinich & Co, finds confirmation for investment ideas as she walks to her Mayfair office each morning.

Recently she noted an increase in the amount of vans emblazoned with the logo of ISS, a business support firm offering services as diverse as cleaning and security, after buying its bonds. She took this as a reassuring signal of the company’s growth. The same went for a particular crane manufacturer whose machines were increasingly visible on the city’s skyline.

“There are many good companies which are not in the public eye, but because we have analysed them and invest in them, I tend to notice these companies when I am out and about,” she says.

Many high-yield companies may tend to be in the less glamorous support businesses. But who cares? ISS, Denmark’s second largest company, recently reported an 11% increase in revenues for 2008 and the semi-annual coupon it pays of 8.875% looks secure.

If ISS’s fortunes are anything to go by, it reflects the popularity of corporate bond funds – both high yield and investment grade – which have featured strongly in recent fund launches and are of increasing interest to exchange-traded fund providers. Crisis environments in the past have seen fund managers push corporate bond products to the front of their displays and 2009 is no different.

Investec Asset Management renamed one of its products as the Investec GSF Investment Grade Corporate Bond Fund in March and pointed out that corporate spreads over government bonds had hit levels not seen since the 1930s.

Quentin Fitzsimmons, fund manager at Threadneedle Absolute Return Bond Fund, says corporates, as well as emerging market bond yields, represent good value for investors that are prepared to buy and hold and can bear significant short-term volatility.

Payden & Rygel Global, based in London, is also rolling out two corporate bond funds, including a global offering. The firm says investors who had been in hedge funds and private equity are reallocating to credit markets after finding that corporates better fulfill their real-return requirements.

For managers who are investing in corporate bond product launches, fund sales justify the action. Cofunds, an investment platform for intermediaries, noted in February that three corporate bond funds topped a sales chart for fixed income.

Issuers have also been busy. The first two months of the year saw record levels of corporate bond issuance amongst well-rated companies, and Q1 levels may even beat the whole of 2008.

Beyond yields, it is the security of returns that is also attracting investors.

Greil, at Muzinich, says: “Investors are looking at corporate debt because of the shortfall in company profits. A company doesn’t have to pay a dividend, but it has to pay its interest on bonds. If you hold a bond yielding 5% until maturity, you know you are going to get 5%. 

“Right now revenues are going down and customers are buying fewer goods. There are also operating costs that still have to be paid, especially if they are fixed costs. A steel producer can’t just switch off furnaces in a downturn or else they will crack. Often in these environments it can take a long time to ‘right size’ companies.

“Companies can cut dividends to support all this, but not interest on bonds.”

Although Muzinich invests in investment-grade corporate bonds, the firm specialises in high-yield and has $5bn (€3.76bn) under management. Credit ratings for high-yield carry a rating of BBB or lower from S&P, and Baa or lower from Moody’s.

For the year to mid-March 2009, returns on European BBB corporate debt increased by 4%, according to the Merrill Lynch High-Yield Constrained Index. BB and B-rated bonds increased by 2.9%.

“The return on BB and B bonds includes financials,” says Greil. “But if you take those out, returns rise by 4.3%.”

The main culprits in the financials sector were RBS and Fortis. Once a bank is part nationalised its tier 1 paper becomes high yield. Muzinich does not own financial paper, says Greil. With financials representing 25% of the European BB and B universe, Merrill Lynch now offers an index that excludes them.

Longer-term performance
Following the dotcom crash, between 2003-2005 returns for European corporate bonds were “very good”, says Greil.
For example, European BBB corporates returned 7.3% in 2004, while from year-end 2003 to year-end 2004, BB and B-rated high-yield bonds returned 13.3%, and including CCC the index returned 14.7%.

After a corporate bond rally in 2006 the market went sideways up until the end of June 2007. Then, in July that year, it collapsed.

But equities didn’t crash until a year later. Greil says: “If you look at the S&P 500, this peaked in May-June 2008 and then trended downwards. It suggests that corporate bonds are one year ahead of the equities market in terms of realising how big a problem the financial crisis is. Corporate bonds will also be first out of the crisis and unless we see a sustained recovery in credit, there will be no recovery in equities.”

Other high-yield companies in Muzinich’s portfolio include Virgin Media, Bombardier, which is a maker of aeroplanes and trains, Colt Telecommunications and Levi Strauss.

Exceptional value, but be wary
The AAA investment-grade corporate bond market, the safest of all in terms of default risk, has been steadily shrinking with
only five firms left in it, according to S&P. But there are still opportunities in the AA and A markets.

Robin Creswell, managing principal of Payden & Rygel Global, says there are several thousand investment-grade securities. But he warns that there are two types with differing levels of transparency.

“There are traditional corporate bonds mostly issued up until two to three years ago by a single corporation and secured against its balance sheet and cashflow.

“Then there are also what we call ‘new age’ bonds. These have been issued in the last two to three years and are secured against multiple issuers. They are parcelled up together and the underlying securities are not transparent. We are not interested in them.”

He adds that many existing corporate bond funds have legacy issues, meaning they might contain asset-backed securities and mortgages, or be made up of 40-60% in financials. Payden recently launched a sterling investment-grade fund, gaining $80m, and a global fund targeting $100m is to follow. Creswell also says an existing high-yield fund picked up $60m in the past eight weeks. 

Following last year’s sell off, John Stopford, cohead of fixed income at Investec, says investment-grade corporate bonds stand out as showing “exceptional value”, over-compensating investors for the risk of potential default and delivering superior risk-adjusted returns.
“History suggests, we believe, that investment-grade corporate bonds could outperform government bonds by up to 10% per annum over the next few years.”

The enthusiasm displayed by some managers is tempered by caution from others. Fitzsimmons, at Threadneedle, says: “While credit markets represent good value for buy-and-hold investors, liquidity remains a problem and, for this reason, we remain wary of these assets in our absolute-return portfolios.”

Ben Bennett, of Legal & General Investment Management, noted that investment-grade corporate bonds currently yield 5% more than government bonds. He says: “History suggests that this is an extraordinary level of compensation for the level of potential annual losses from companies defaulting.”

But there are near-term risks. In an environment where economic growth is slowing and corporate profits shrinking, credit deterioration appears inevitable, he says. Yet there is considerable dispersion within the marketplace, with companies less tied to the economic cycle significantly outperforming cyclical corporate bonds.

“Cheap bonds are cheap for a reason, with the coming months set to witness a high number of downgrades and associated volatile price action.”

But Bennett adds: “A managed corporate bond portfolio which successfully buys riskier bonds while maintaining a strict approach to risk management, could produce significant excess returns in 2009.”

©2009 funds europe

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