The downgrade of Greece’s debt to junk status dominates the backdrop for corporate bonds. For a year, the markets watched as the drama unfolded; the country’s deficit ballooned, its GDP slumped and local banks suddenly faced soaring funding costs. Germany and even the UK are benefiting from safe-haven flows, while peripheral eurozone economies such as Italy, Portugal, Spain and Ireland have seen yields rise sharply.
Most global corporate bond funds do not of course own lowly-rated Greek or even Portuguese banks and in Spain they own only the internationally-focused banks BBVA and Santander. The fear is contagion across the sector, and events have been moving rapidly, with investors beginning to shun company debt on concern that the €110bn rescue package will not solve the Greek deficit crisis.
Investment grade spreads have jumped back to 160 basis points, 590 for high yield, harking back to the end of 2007, when unprecedented economic conditions led investors to demand around 180-190 basis points for the risk of holding investment-grade corporate bonds, and over 500 basis points for holding speculative paper.
With interest rates likely to remain close to the current low levels until the end of the year, and with modest economic growth widely anticipated, current spreads arguably represent an attractive opportunity, as they are a good deal more than an investor will earn on deposit in a bank and the renewed positive growth outlook for businesses increases the likelihood the coupon will be paid.
The days of a beta play in corporate bonds are long gone, however, and the focus has turned emphatically to careful name picking.
“If growth continues to pick up, and interest rates slowly begin to return to normal, then the recovery will be good for bonds because balance sheets will strengthen,” predicts Robin Creswell, managing principal at Payden & Rygel.
Tightening spreads
“There will also be room for spread tightening, so investors will receive the coupon and potentially capital growth. Spreads could come in by as much as 30-40 basis points by the year end.”
Many managers had been reaching down to BBB or BBB- rated bonds where they were compensated by incremental spread. A-rated companies such as utilities might earn 70 basis points over gilts, but BBBs had been offering nearly three times that.
“Quality rotation is the name of game,” says Mr Creswell. “If the outlook stays stable, most [BBBs] are in a good position because, for example, they have taken measures to repair their balance sheets by reducing Capex, shareholder dividends and buybacks, which all help to conserve cash and cut ongoing costs. The lack of complacency about economic recovery has helped the outlook for bonds.”
Although spread tightening is already taking place, he likes BBB names in consumer retail, such as M&S, Next and Kingfisher, and in automotives, business services and internet media.
But although some managers are delving deeper into the credit ratings, some are also boosting their diversification and reducing their risk by increasing the number of their holdings. Standard Life Investments’ European Corporate Bond Sicav currently holds 6 per cent in high yield. The mandate allows up to 10 per cent, but although the economy is slowly improving, manager Craig MacDonald believes some companies will not be able to pay down their debt.
Mr Macdonald has increased the fund’s diversification from approximately 100 companies in early 2007, to more than 150 companies, given the level of economic uncertainty and the asymmetric risk of bonds, where the upside is limited to the yield and the downside is typically a 60-80 per cent loss, which is so different to equities.
Most managers are also looking for companies with above average exposure to growth in the US, which has now seen employment growth for the third consecutive month, and in emerging markets, which are not grappling with the challenging systemic issues of the West. A typical example is basic materials geared to infrastructure development in China. Mr MacDonald, for example, likes export companies like Xstrata, US-facing car manufacturers such as ABB or materials companies such as HeidelbergCement.
Global fund managers are also keen on emerging market debt itself, particularly use of local debt as currencies across these regions such as the Brazilian Real have been strengthening.
Banking sector
There is less consensus about the outlook for the banking sector, where spreads have widened reflecting uncertainty about the regulatory forces at work and the potential break up of big banks. Arguably, they may also suggest a certain complacency pre-crisis.
