Fundamental reasons to be mildly cheerful

European corporate bonds defied the predictions of many commentators and fund managers by performing better than expected in 2004. Over one year to December 1, 2004, for example, the Citi European WGBI Eur index returned 8.42 per cent. Over three years, the index delivered 18.8 per cent and 35.77 per cent over five years. But there are reasons why investors may be cautious about the outlook for 2005. Spreads with government bonds are historically tight and therefore likely to move in only one direction, argue the killjoys. Furthermore, corporate bonds are relatively expensive. Nevertheless, Rodrigo Araya, manager of the Lombard Odier Euro Corp Bond A fund, which has returned 19.22 per cent over three years, just above the Citi index, says corporate bond valuations may be stretched but fundamental factors are still supportive of prices. He adds that investment grade spreads will be stable in the first half of 2005 and out-performance by funds will come via credit selection this year. “Even though valuations are stretched, we do not believe there will be much volatility in spreads. Prices are tight but given the fundamentals they are not too expensive,” says Mr Araya. “Despite the pick up in M&A activity and because of strong free cash flow, moderate economic growth and de-leveraging by companies, this is a good environment for corporate bonds.” The biggest potential risk to European corporate bonds, according to Mr Araya, is a substantial decline in the value of the dollar, which would increase volatility and therefore might have a negative effect on spreads and on the earnings of companies that export to the US. Of the sectors favoured by Mr Araya, he highlights subordinated financials. Indeed, this is a sector mentioned by all corporate bond fund managers. “Insurers and banks still offer an attractive spread and greater pick up potential than some industrial sectors. We also like the telecoms sector, particularly France Telecom and Telecom Italia. Telecoms have strong free cash flow, have de-leveraged, their balance sheets are healthy and they are enjoying organic growth.” Lombard Odier is most cautious about the automotive sector. “Companies such as GM and Ford are fighting to survive so we do not feel comfortable about buying their debt at the moment.”

word of caution

Peter Sass, manager of the €968.75m DWS Euro-Corp Bonds fund, which has gained 20.38 per cent over three years compared to 18.8 per cent by the index, says he does not expect the performance of European corporate bonds this year to be as good as in 2004.

In contrast to other fund managers, Mr Sass believes the European Central Bank will raise interest rates over the next 12 months. He estimates that European interest rates could be increased by 40 basis points. If interest rates rise then this would mean corporate bond yields would have to increase as well. This is because buyers will only purchase bonds if the rewards compensate for the riskier nature of the investment over government bonds and therefore yields will have to rise in line with interest rates. This will thus push down the price of corporate bonds, leading to investors suffering capital losses. Nevertheless, Mr Sass says the spreads between corporate and government bonds are likely to remain stable. “We expect moderate economic growth this year. Almost every sector has been able to improve its credit quality, there are low levels of defaults and there have been more rating upgrades than downgrades,” says Mr Sass. “There are only one or two sectors vulnerable to downgrades. These are US car manufacturers with bonds issued in Europe, and UK retailers. “US car manufacturers face a number of problems. These include the fact they have been providing large incentives to sell their cars. Many have been making more money from their financial side in lending money to customers than the profit on selling cars. Many of these companies also face large pension fund deficits.” Mr Sass adds that he is cautious about retailers in the UK because of the high level of debt among consumers and therefore wonders how sustainable their spending is. The DWS fund has overweight positions in subordinate financials. “The credit quality and free cash flow of banks has been improving. Among the stocks we like are Barclays and Deutsche Bank,” says Mr Sass.

issuance outlook

The fund has moved to a slightly short duration position to reduce exposure to price falls in corporate bonds following a potential rise in interest rates in 2005. Price movements in corporate bonds will also be affected, however, by the level of issuance in 2005. Mr Sass believes issuance will decline in 2005 for the second consecutive year. Less issuance, of course, should support bond prices this year as more investors chase fewer bonds.

Predictions about the outlook for corporate bonds are not easy, however. Raffaele Bertoni, manager of the €1.26bn Pioneer Euro Corp Bd E Eur fund, which has also outperformed the index over three years with a return of 19.08 per cent, says the consensus at the start of 2004 was that it would be a difficult year for European corporate bonds. He attributes the better than expected returns to a number of fundamental reasons, which have led Mr Bertoni to declare the environment for corporate bonds is still positive. “Companies have generally been reducing their leverage and strengthening their balance sheets,” says Mr Bertoni. “For companies in Europe and the US, the balance between the debt ratio and the free cash flow has improved. Even many high yield companies have reduced their debt to the levels of 1993 and 1994. “The corporate bond market is also well supported by technical factors. The supply of bonds is much lower than expected because companies have been paying back debt. But demand is still relatively high as investors continue to look for extra yield. Institutions and pension funds have been happy to take the extra risk for the higher returns from corporate bonds than government bonds. “Investment grade bonds have an average spread over government bonds in Europe of 45 basis points at the moment. In contrast, high yield has an average spread of 212 basis points above government bonds.”

tight spreads

Even though these spreads are at historically tight margins, Mr Bertoni does not expect a significant widening this year. This is because he believes interest rates will remain low and demand for corporate bonds will stay high. “There is no particular reason why spreads should widen. We do not expect a sell-off as investors will continue to look for the extra yield corporate bonds can provide.”

Mr Bertoni argues that interest rates are unlikely to rise in the near future. He bases this view on the fact that Europe is still suffering from weak economic growth. “The US economy has been growing at around 3 per cent a year, which provides the Federal Reserve with greater room for manoeuvre. In contrast, economic growth in Europe is limited and is currently expanding by between 1 and 1.5 per cent a year so there is no reason for the ECB to change its interest rate policy. We expect moderate economic growth in Europe this year while in the US it will match the long-term trend.” Despite this benign economic environment and positive technical factors, Mr Bertoni is cautious about the price of investment grade and high yield corporate bonds. “It could be argued that corporate bonds are too expensive. It is difficult to see how there could be more tightening of spreads between corporate bonds and gilts. We expect a total return of 3 to 3.5 per cent from corporate bonds in 2005 compared with the 7 to 8 per cent in 2004. Most of the total return in 2005 will be from yield rather than capital gains.” Nevertheless, Mr Bertoni, who favours investment grade bonds over high yield, says prices will be supported by institutions continuing to invest in credit. He also identifies subordinated financials and telecoms as favoured sectors because “the credit quality is stable and cash flow has improved. This has meant that telecom companies generally do not have to issue new debt.”

technical factors

Cian O’Carroll, head of euro credits at Fortis Investments, stresses the importance of technical factors in the price of corporate bonds. He believes corporate bonds are at reasonable valuations and adds that the technical factors are unlikely to alter in the next few months.

According to Mr O’Carroll, what will change the market, however, during 2005 are different movements in interest rates in the US and Europe. He argues that US interest rates are more likely to continue to rise into 2005. This will lead to a greater spread between yields on US corporate bonds than those in Europe. “Spreads between corporate bonds and gilts in Europe are too tight and will widen but this will not be substantial,” he says. Martine Wehlen-Bode, co-fund manager of the UBS Bd Sicav € Corp B fund, does not believe interest rates will be raised by the ECB in the first half of 2005. “The concerns over permanently higher energy costs still send dark clouds over euroland growth prospects and make a rate rise very unlikely during the first half of 2005. The market does not expect a hike of around 25 basis points before the end of the third quarter in 2005. “Nevertheless, neither do we believe that growth prospects are already sufficiently tarnished, nor has inflation – fuelled by the same rise in the oil price – been reigned in sufficiently to warrant current euroland yield levels. As a consequence, we are keeping the portfolio’s duration lower versus the benchmark.” Ms Wehlen-Bode says UBS is cautiously positive on the market and believes spreads over government bonds will be stable over the next few months. “Therefore, corporate holdings are attractive versus government bonds. We prefer names offering spread pick up versus the market and performance will come more from yield rather than capital gains. Nevertheless, security selection and avoidance of fallen angels will remain key.” Gary Potter, co-head of the Credit Suisse Portfolio Service, which chooses from the best funds in the European market, also does not believe the ECB will raise interest rates in the first six months of 2005. This is likely to support corporate bond prices but Mr Potter warns that spreads may be “choppy” this year. “The strong euro relative to the dollar will act as a restraint on the euroland economies. More expensive exports will make manufacturing companies less profitable and may lead to job losses,” says Mr Potter. “This will mean the ECB will not have to raise interest rates. But with US interest rates likely to be increased further during 2005 then there will be a differential in yields with the US.”

Inflationary concerns

Mr Potter says Credit Suisse is cautious on corporate bonds relative to equities because “we do not see growth falling off a cliff this year. Inflation may tick up as a result of the high oil price but it will not be dramatic”.

He invests in corporate bond funds that have flexible investment mandates such as the Threadneedle Strategic Bond fund. Mr Potter argues that the advantages of these funds are their ability to switch between different grades of credit, notably investment grade and high yield as well as emerging markets. “The good fund managers will be able to increase income payments while the bad managers will suffer capital losses and hold income payments.” Mr Potter adds that he also likes the Lombard Odier Euro Corp Bond A fund.

‘US car manufacturers with bonds issued in Europe and UK retailers are vulnerable to downgrades’
Peter Sass, DWS