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Magazine Issues » November 2013

CORPORATE BONDS: A load of noise

MegaphoneInvestors have pulled back from corporate bonds in 2013. Fiona Rintoul asks if the asset class has anything more to give.

Bond managers, certainly, are no more buying into the Great Rotation theory this year than they were last year. A Small Rotation may be conscionable but, as was the case the last time the topic was current, it’s thought more likely it will be out of cash into equities than out of bonds.

“The discussion about tapering in US quantitative easing is a load of noise,” says Andrew Main, principal at Stratton Street Capital. “There isn’t going to be a major change in monetary policy in the G7 countries for the next two years.”

Nonetheless, there have been outflows from corporate bond funds – concentrated in the investment grade category. For year-to-date 2013, Lipper reports redemptions of €6.3 billion for European investment-grade corporate bonds funds, €4.8 billion for investment grade in the UK and just shy of €1 billion for the same category in the US.

Lower yields and expectations that the sell-off in government bonds might yet prompt the chimerical Great Rotation had pushed investors to abandon investment-grade corporate bonds by September. But any notion that better yields can be found for the equivalent or lower risk may be misplaced.

“Real yields on developed-world government bonds are close to zero or negative in some cases, and the pick-up on corporate bonds relative to the risk-free rate is substantial,” says Nigel Jenkins, senior fixed-income strategist and director at Payden & Rygel.

Jenkins cites the example of euro investment-grade corporates, which are currently yielding just over 2% on a five-year maturity. It’s hardly a king’s ransom, but cash rates are close to zero.

“If cash rates stay at that level for at least another two years, they would need to rise very sharply in years three to five to provide a better yield than euro corporate bonds.”

It all depends on whether you think the current situation of low interest rates and satisfactory but not stellar economic growth will persist. Other commentators – on the bond side at least – are with Stratton Capital’s Main in thinking it will.

“Most sectors of the corporate bond market have been remarkably resilient in the face of uncertainty over tapering,” says Rich Smith, portfolio manager at Aberdeen Asset Management. “The overriding view appears to have been that central banks are unlikely to do anything to choke off recovery before there are real signs that it is sustainable.”

Basically, government bonds – certainly within the developed world universe – look set to remain out of favour, but the case for corporate bonds of all types is still there.

“The prospect of a tapering in US quantitative easing has prompted a significant sell-off in core government bonds and has put a little bit more value back in these markets,” says Michael Matthews, fixed- interest fund manager at Invesco Perpetual.

“However, we still prefer credit risk to interest rate risk.”

And while there have been flows out of corporate bond funds, as illustrated by the Lipper statistics, institutional investors have, if anything, been placing more money in corporate bonds.

“There is a big trend for investment out of government-oriented bond mandates into more corporate-heavy mandates and emerging market bond mandates,” says Jenkins.

Clearly, though, yields of a bit more than 2% aren’t going to set the world on fire. Therefore, investors who are able to take on more risk are looking further than investment-grade corporates in the developed world.

“Managers will have to dig deeper to generate returns going forward, but we remain positive on the prospects for corporate bond investors to earn a decent yield,” says Smith. “Broadening the opportunity
set certainly helps in this regard as non-traditional sectors such as emerging markets and high yield, particularly in Asia, continue to offer attractive opportunities.”

In both emerging markets and high yield, this broadening has been facilitated by increased availability. Only a few years ago, corporates in emerging markets didn’t issue dollar bonds. There has been a revolution in product availability since then.

“The big thing that happened in corporate debt this year was that there is now more corporate debt than sovereign debt in emerging markets,” says Main.

This partly reflects issuance by semi-government debtors, which are classed as corporates. But it is also a result of a deleveraging world.

“Banks are less able to lend because of new regulations,” says Main. “Therefore, there’s been a big push in emerging markets to find new ways of financing.”

For an investor such as Stratton Street Capital, which avoids bond indices because it wants to “invest in countries that repay debt rather than countries that are persistent debtors”, this provides an attractive portal into the future. The company says pension funds should be thinking about what the world will be like two decades from now.

“They need exposure to places that are not as important now as they will be in 20 years’ time.”

For investors who believe the fundamental picture in emerging markets has not changed, the recent noise around tapering also has an upside.

“The proposed withdrawal of US liquidity sent a valuation shockwave through emerging markets, where liquidity is especially precious,” says Smith. “The perception in the market is that investors will be less willing or able to support emerging economies. From our perspective this has generated investment opportunities.”

New ways of financing are also keeping supply buoyant in developed-world high-yield bonds. Contrary to what might be expected, slowly improving economic growth has not led to a trend of corporate upgrades.

“Some corporates that sink to junk and become high-yield are less likely to go back when they’ve made that change,” says Colm D’Rosario, senior portfolio manager for high yield at Pioneer Investments. “They may be inclined to manage the company on behalf of shareholders and live with a higher level of leverage, especially in Europe.”

High yield bonds have the additional advantage of being a shorter duration asset class and therefore less sensitive to movements in underlying interest rates. This, combined with low default rates, makes high-yield an interesting if not overwhelmingly compelling buy.

“High yield continues to look attractive from a returns perspective as investors can still achieve higher coupons this way,” says D’Rosario.

However, Jenkins says Payden & Rygel would allocate around 5-7% to high yield in a portfolio where the neutral position was 100% investment grade.

Another way to dig deep is to invest dynamically – a theme that has dominated both bond and equity investment lately.

“We believe that different sub-sectors of the market present different industry, credit quality and maturity characteristics and these differences bring opportunities,” says Smith. “In order to capitalise on these opportunities a fund needs to rotate assets.”

At the moment, many corporate bond investors see particular value in financials.

“The yields available in the financial sector are certainly not as high as they were two years ago, but the risk has fallen too,” says Matthews. “There is also a scarcity value in the sector. Banks have so much liquidity that there is significantly less issuance of bank debt, particularly senior bonds.”

Outside financials, another pocket of value is hybrid debt instruments. Hybrids provide exposure to credits considered to be very default-remote, such as utilities, and provide a significantly higher yield in return for taking some subordination risk.

“Italian utility Enel recently issued a multi tranche deal with coupons ranging from 6.5% to 8.75%, for example,” says Matthews.

Corporate bonds aren’t dead yet, then, though there are risks ahead. Tapering must happen eventually and an improving economy may provoke corporate actions such as mergers and acquisitions that could have a negative effect on credit spreads. Nonetheless, bond fund managers are optimistic about the longer term outlook for corporates.

©2013 funds europe