Credit funds have experienced record inflows this year as investors shun expensive government bonds and the low rates available on cash. The corporate bond sector is an asset class where yields on investment grade of 7 per cent are possible, and with little further downside risk, as the markets have already priced in pessimistically high default rates.
“There are keen buyers for these funds from two pools,” says Ric Ford, portfolio manager of Morgan Stanley European Corporate Bond Fund.
“The first are those investors looking to switch out of Government debt, and the second are those with big cash balances looking to switch into credit. There is enormous demand for supply,” he adds.
Investment grade
“Money market rates have dropped down dramatically and will probably not rise again this year but will stay low for a long period,” predicts Jan Van Parys, fund manager of KBC Corporate Eurobond fund.
“Whereas an investor might achieve 1 per cent on a money market fund, he can invest in corporate bond fund and get 4-5 per cent,” he says.
“So what you’re seeing is investors moving out of money market funds to corporate bond funds, which coincides with some better signs for the economy as the rate of deterioration is getting slower,” adds Mr Van Parys.
The incentive to move to investment grade has similarly proved attractive to life assurers, which are guaranteeing 4 per cent to their policyholders, and pensions funds, which need 4 per cent to maintain pensions in payment. Multi-asset funds have also been big buyers as the asset class remunerates well for risk.
A large part of the attraction is that bond spreads are unrealistically wide compared with gilts. “Currently spreads of 500 basis points in investment grade indicate that one third of all European investment grade issues are expected to default in five years,” says Raphael Robelin, senior portfolio manager at BlueBay Asset Management.
“These valuations are attractive because they are already pricing in the worst possible economic outlook,” he explains.
Even during last year’s difficult conditions, the default rate on investment grade was 0.4 per cent, weighted by issuer. Calculated on a debt basis, despite Lehman's $200bn (E147.5bn) of debt, the default rate was limited to 1.4 per cent. The current market spread is implying default within one year on senior debt of 19.5 per cent, assuming a recovery rate of 30 per cent.
“We believe the expected default rate on investment grade credit within one year will be no more than 1 per cent, so the remuneration largely exceeds the underlying risks,” says Isabelle Rome, head of credit strategy at Dexia Asset Management.
In high yield, the forecast as implied in spreads is for a 23 per cent default rate in a year, assuming a recovery rate of 20 per cent. Ms Rome’s estimate of default in the high yield category is around 18 per cent, so this spread is again pricing in more than her forecast.
Marked improvement
The market has improved a great deal since it hit bottom in mid-March. The iBoxx Euro Corporate Investment Grade index is now 415 basis points over Government bonds, but was 515 basis points in early April.
In the high yield space, the Merrill Lynch High Yield Index of BB+ to CCC-rated bonds, shows a risk premium of 1845 basis points over government bonds but had been over 2200 basis points in mid-March, while the benchmark iTraxx Crossover index, which reflects 50 mostly junk-rated credits and is an important indicator of sentiment, has rallied significantly – up to 800 from 960 in mid-March.
Latterly, however, there have been some creeping fears over the sheer volume of new issues this year. The value of euro-bond sales in the first week of May set a new weekly record with issues from Swedish utility Vattenfall, oil major Royal Dutch Shell, French car manufacturer Peugeot Citroën and hypermarket chain Carrefour raising €14.1bn of bonds.
This has taken the total issuance this year to €146.8bn, the third-highest value of euro corporate-bond sales in any full year, according to Société Générale, which says the primary market is on course for a healthy and robust new issue pipeline for the rest of 2009.
While the issues, which are all high quality names, continue to be heavily oversubscribed, the risk of oversupply has risen abruptly.
That bonds are being bought not in the secondary, but in the primary market, will somewhat limit the ability of the market to rally, predicts Bluebay’s Mr Robelin.
“It is a healthy dynamic, but it does mean investors can afford to be picky and need not be rushed. They can wait for the next primary issue rather than having to use the secondary market, so we are less likely to see a big squeeze in credit spreads,” he explains.
