Bond returns have been fantastic for the last two years, with high yield delivering over 60 per cent in 2009, and a still-attractive 15 per cent last year. Any remaining scope for spread contraction is therefore limited, and the market has consequently become yield-based, with fund managers managing down their clients’ expectations towards mid-single digit returns.
However, this is a well anchored market, supported by improving corporate balance sheets, strengthening credit quality and enduring investor demand for income.
DECENT RETURNS
“The return on the asset class in 2009 was a once in a career opportunity – spreads were at an all-time wide and we enjoyed the fruits of their contraction,” says Paul Read, co-head of fixed income at Invesco.
“That lasted through that year and into 2010. We are left with a market where there is no obvious opportunity for additional spread contraction but which for the most part will provide you with a decent yield-based return.”
The future for corporate bonds now depends on what the European Central Bank (ECB) does about rates – whether there is a meaningful rate hike or a modest adjustment, says Mr Read. “If you believe, as we do, that inflation will ultimately moderate and yields remain modest for some time, then this is still an asset class that can deliver a decent return over the risk-free alternatives. Over the next 12 months, we’re really looking at this as a yield story – there are only one or two parts of the market where we might also anticipate further spread tightening.”
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The focus has turned away from investment grade bonds, which are more sensitive to rate rises, towards high yield, where that small further contraction may occur.
“Although corporate bond valuations are nowhere like as attractive as they were at the start of 2009, with BBB+ spreads currently at an average of 170 basis points over government bonds, they are still at the point they were in 2002, even though corporate balance sheets are in much better shape today,” says Raphael Robelin, senior portfolio manager at BlueBay AM.
“If you look at historical default statistics, using Moody’s default and migration statistics going back to 1980, investors have typically only needed 19 basis points to compensate for the credit risk when investing in BBB+ corporate bonds for five years,” he explains.
“Even during the worst five-year period on record, in 1998-2003, when there were several fraud cases including Enron and Parmalat, investors only needed 47 basis points of compensation for the default risk they faced, so it is hard to argue that you’re not being paid attractively for risk at current levels.”
LOW DEFAULT RATES
Default rates should stay low, according to indicators such as the latest forecasts from ratings agency Moody’s, and the Schroder Global Credit Trend Index, which is based on an assessment of over 1,000 corporate bond issuers.
“While economic growth is likely to be modest, it should be enough to give a positive backdrop for attractively valued corporate bonds, which we believe largely reside within the more cyclical and economically sensitive parts of the market,” says Adam Cordery, fund manager at Schroders.
However, there is a certain downside associated with businesses accumulating cash on their balance sheets – they may be tempted to use it to keep shareholders sweet or to embark on further leverage such as debt-financed M&A and Capex increases.
“We’re likely to see more shareholder-friendly behaviour,” says Jamie Guenther, head of US Institutional Credit at DB Advisors. “Probably the biggest dynamic is an increase in M&A and share repurchases and theoretically these are credit ‘unfriendly’ and place restraints on spread performance going forth.”
Historically, credit has performed well when growth in developed economies is between 1-3 per cent, which sits well with current levels. “Any less and defaults rise, but if growth is stronger, then managements often become too bullish,” says BlueBay’s Mr Robelin.
Like many managers, he currently prefers the lower end of credit spectrum – crossover and BBBs – because this group of companies is generally focussed on financial discipline and committed to their credit ratings. It is managers of higher rated investment grade companies that are under most pressure to take on additional debt to boost their stock price and keep shareholders happy.
A lot hinges on whether government bond yields move much higher. While inflation is creeping up, the sources are cost push – a combination of energy and commodity prices, and there are impediments to growth which are a drag on inflation such as limited lending. This is therefore not a backdrop in which the labour market has much power to respond to higher costs, and inflation and rates are likely to stay modest.
