Low volatility means it pays to be choosy

European corporate bond spreads remained at historically tight levels in 2005. There was some volatility in March and the autumn, but spreads were at similar levels at the start and end of the year.

This continues to raise questions about the potential for total returns among European corporate bonds. A benign economic environment is likely to lead to little capital growth, but a stable yield. But a deteriorating economic landscape, rapidly rising inflation and/or interest rates and more merger and acquisitions could see capital losses for corporate bonds.

The stability of spreads is reflected in lower short-term returns by European corporate bond funds. According to Standard & Poor’s, the average corporate bond fund returned 31.63 per cent in the five years to 21 November 2005. This was in contrast to 17.24 per cent over the past three years and just 3.3 per cent over one year.

There was some volatility in spreads in the autumn of 2005, however. The average spread for BBB bonds on the Merrill Lynch EMU index reached a low of 75 basis points on 29 September 2005. By 6 December, the spreads had widened to 93 basis points. The average spread of A-rated bonds widened from 42 to 49 basis points.

The spreads on high yield bonds reached their low point later but widened at a quicker pace. The average spread on high yield bonds on the Merrill Lynch EMU index were 319 basis points on 27 October but reached 358 basis points on 6 December.

Paul Lavelle, manager of the Fidelity II Euro Corporate Bond fund, disputes that spreads have been too tight. Rather he believes they have been justified by fundamentals in the corporate bond market. “Default levels have been low, there has been low volatility in the markets and companies have been de-leveraging and improving their balance sheets since 2002.”

He attributes the widening of corporate bond spreads in Europe in the autumn of 2005 to a number of factors. These include the pick up in M&A activity in Europe in 2005, particularly private equity deals through leveraged buy-outs. Mr Lavelle says these deals invariably add a lot of leverage to companies. “Private equity firms leverage up the balance sheets to pay for the acquisitions. It may go from two or three times leverage, for example, to six or seven times.

“It is not just the bonds of firms subject to deals that have been affected. The rumour mill is suggesting companies that may be subject to leveraged buy-out deals every day, which in turn affects their prices.”

There have been comments that default rates may rise in 2006, but Mr Lavelle does not see this as a significant threat to corporate bond markets. “Every year there are predictions of default rises but we do not believe there will be a dramatic increase next year.”

Mr Lavelle is also not concerned about a dramatic rise in interest rates in Europe. The European Central Bank (ECB) raised base rates in December for the first time in five years from 2 to 2.25 per cent. He believes the market has priced in two more 0.25 per cent rises so even if base rates reach 2.75 per cent, the market will not react negatively. “We do not envisage the ECB raising rates in the same way as the US Federal Reserve and it is unlikely base rates will go above 2.75 to 3 per cent,” says Mr Lavelle.

Among the investment opportunities identified by Fidelity are cross-over bonds. These are high yield bonds which are expected to move up to investment grade over the next six to 12 months. Fidelity claims to have found “a few investment opportunities” among BB bonds, including Ahold.

Mr Lavelle also cites buying opportunities further afield, including banks in Russia and Kazakstan. The Fidelity II Euro Corporate Bond fund has been increasing its exposure to banks and financial companies in the European market generally.

Increased exposure to banks and financial companies is a theme also being pursued by Raffaele Bertoni, manager of the Pioneer European Corporate Bond fund. This is partly because Mr Bertoni has been switching out of sectors subject to a high proportion of the M&A activity to those where there have been fewer deals.

Pioneer’s fund also has a 5 per cent exposure to sub-investment grade bonds, which is the maximum allocation allowed. Of this, 3 per cent is invested in emerging markets within Europe and 2 per cent in high yield bonds. This is an attempt to gain extra yield for the portfolio and reflects Mr Bertoni’s confidence in a benign environment for corporate bonds in Europe.

Indeed, he believes 2006 will be a similar year to 2005 for European corporate bonds. “We think the low volatility and tight spreads we have seen in 2005 will continue in 2006,” says Mr Bertoni. “There was only some volatility in March and October. The volatility in March was due to concerns about possible losses from hedge funds’ investments in corporate bonds.”

Mr Bertoni believes yields will be stable in 2006, even though he says the corporate bond market is generally quite expensive. But he adds that the prices are being supported by fundamentals. “The macro economic environment in Europe is improving, which is supportive of corporate bonds.

Support is also coming from the fact that companies have been improving their balance sheets over the past couple of years and credit rating agencies are expecting default rates to remain low next year. Furthermore, he does not expect interest rates to rise significantly in 2006.

“This is because we see few inflationary pressures although a strong rise in the oil price is one threat.” Another risk, says Mr Bertoni, is a growth in leveraged buy-out deals.

The Pioneer Euro Corp Bond fund out-performed the Merrill Lynch EMU Corporate index over one year to 21 November 2005, but has under-performed over the past three years. Mr Bertoni says that the relative out-performance of the past year is partly due to the investment in the fixed interest team that Pioneer has made. For this particular fund, the five credit analysts are supported by the 23-strong European equity research team at Pioneer.

For funds in this sector, a comparison with the Merrill Lynch EMU Corporate index does not always present a true picture. For example, for its benchmark, the Pioneer Euro Corp Bond fund uses 95 per cent the Merrill Lynch EMU Corporate Bond Large Cap index and 5 per cent the JPM Cash 1 Month Euro index. Some funds may use other indices, such as the Lehman Aggregate.

The ING (L) RF Eurocredit fund takes a different approach from other funds by only focusing on investment grade corporate bonds. Han Rijken, the fund’s manager, identifies support for corporate bonds coming from a lack of increase in issuance of new bonds in Europe. With demand for corporate bonds high, says Mr Rijken, the lower issuance in 2005 compared with 2004 has supported prices.

But Mr Rijken warns corporate bonds in general do not look cheap and there is not great potential for capital growth. “There are investment opportunities, but it is important in the current environment for investors to be selective in which bonds they buy.”

This is a theme reiterated by Martine Wehlen-Bodé, manager of the UBS BS-Eur Corporate Bond fund, who says he has made the portfolio slightly more defensive by focusing on industries with limited event risk. “On one side, strong fundamentals as well as attractive demand-supply patterns are supportive for the market,” says Ms Wehlen-Bodé.

“However, shareholder value orientation of companies and M&A risk could be negative for the corporate market. We are more cautious on the market, especially towards high beta names. Corporate holdings can still be attractive versus government bonds but security and avoidance of fallen angels will remain key.”

According to Ms Wehlen-Bodé, the UBS fund is overweight AA bonds because of what he sees as attractive spreads and fundamentals for this asset class. This mainly comprises overweight positions in financial subordinated issuers.

She says: “We are overweight regulated industries, namely financials and utilities, while we are underweight the industrial sector. Within the financial industry, we favour the financial subordinated paper (LT2) over financial senior bonds. The LT2 bonds offer attractive spreads for banks with strong fundamentals.”

Robert Burdett, co-head of the Credit Suisse Asset Management multi-management service, says he is wary about corporate bond markets at the moment, including in Europe. “We are wary because the markets are hanging on every word of the central bankers and looking closely at every figure on interest rates and inflation.

“Over two days, for example, corporate bond spreads in the UK widened by 1 per cent. That is significant volatility for bond markets. This is partly because the market is divided into two camps. On one side are investors concerned about recession and on the other are people worried about inflation.”

In this environment, Mr Burdett says he is focusing on funds that can be flexible and have the ability to use this flexibility. “The Gartmore Corporate Bond fund, for example, can invest in government bonds and cash as well as corporate bonds. There will be trading opportunities in the future between government bonds and credit.”

Lavelle: spreads are not too tight