Appetite for corporate bonds remains despite low yields

Today’s bond market is a different place from five years ago, when almost the entire focus was on whether investors were adequately compensated for the level of default rates. To a degree, the universal hunt for yield has eclipsed the preoccupation with risk and pushed investors down the credit ratings in search of better returns.

Investors have a voracious appetite for European high yield bonds and companies have taken advantage of demand to issue low coupons, setting new milestones in a multi-year bond rally. In the first week of May, more than €5.6bn of junk bonds were issued by European companies, the strongest week for issuance in two years and the third best week on record, according to Dealogic.

The same week saw average yields on sub-investment grade European corporate bonds fall to an all-time low, below 5.5 per cent, while the average yield on US junk fell below 5 per cent. In investment grade, Apple’s $17bn (€13bn) iBond issue was the largest ever corporate debt sale, even though investors are being paid just 2.4 per cent on 10-year debt and 3.9 per cent on 30-year debt.

Investors are still hungry for bonds despite their record low yields, because they are not focusing on the size of yields compared with historical norms, but instead are comparing corporate bond yields with cash and government bonds, against which they continue to look attractive. Investment grade funds can pay 4.5 per cent if all goes well, with the return generated by ‘carry’ and alpha generation, and perhaps a tiny amount from spread tightening.

Already in the first quarter of 2013, large cap corporate bonds have made 2.14 per cent, which is much better than 1.7 per cent pa from US Treasuries.

Flows are still supportive of the asset class and fears of higher interest rates have receded from the start of the year as the global economy shows signs of slowing, while falling inflation has also strengthened the case for owning fixed rate debt.

“As long as there is quantitative easing, the story is not about valuations any more but about the flow business and supply and demand factors,” says Tanguy Le Saout, head of European fixed income at Pioneer Investments. “Investors have far too much cash and corporate bonds are a good area to put money to work because it is considered safe and supply is short. Furthermore, all the signals from central banks are that rates will be cheaper for longer.”

HIGH YIELD

High yield in particular is a growing opportunity set. In Europe, including financials, it is a €230bn market, just one seventh of the €1.56tn investment grade market, but the proportion is rising as there are more downgrades, price increases and new issues.

“It’s a new paradigm for fixed interest investors,” agrees Chris Bullock, fund manager at Henderson. “The boundary between high yield and investment grade has blurred. Six years ago, pretty well all sovereigns were rated AAA, while today only three to four sovereigns are, and Italy and Spain are close to high yield ratings. High yield has been in a huge transition down the credit ratings and the corporate bond index itself has moved down three notches. The risk-free rate used to be AAA, but it is not really clear what that is any more. Investors have had to adjust. Pension funds have had to tweak mandates to enable them to invest in markets – because where else are they going to invest that money?”

He points to the example of Spain, which is going to BBB- (ie.BBBnegative) as it has missed its deficit targets again. “It is on a negative outlook from three of the rating agencies – one notch down would be high yield, and then it could drag all its corporates with it,” he says.

For corporate bonds, however, we are in an unusually sweet spot – but one that could prove very temporary. Corporate bonds perform best in periods of steady but low growth. Any volte-face on monetary policy would see investors heading for the door, while any downturn in economic data might signal a reverse in current low corporate default rates. Signs of either a weaker or a stronger economic growth could both potentially destabilise bond markets.

“One potential source of volatility will likely be markets becoming concerned about the imminent withdrawal of policy stimulus, whether or not that turns out to be the case,” says Lewis Aubrey-Johnson, product director, at Invesco.

Although recent economic data has slightly disappointed, if that were to change, investors’ attention could quickly turn to the prospect of policy tightening. “If economic data recovered, particularly in the US where there are signs of stronger data, so the market could become worried about the cessation of QE. The repair of consumer and financial balance sheets in the US is well under way and the property market is recovering.”

It is difficult to see a pick up in growth in either the UK or US, says Mr Aubrey-Johnson. UK debt is the biggest as a proportion relative to its economy. However, if US government bond yields significantly increase, then this will likely percolate through to other markets, he says.

Any reversal could also be quick because banks can no longer hold high levels of corporate bonds on their books as a result of tighter regulation, limiting their ability to act as market-makers, which would exhaust liquidity more rapidly in a downturn. Trading volumes are also low, which would exacerbate concern about investors’ ability to exit positions.

Currently, there is relatively little focus on default rates as companies are cautious and prudent, and capex is low. But the impact from the withdrawal of liquidity is harder to assess.

“When looking at default risks, a key driver is a company’s lack of ability to refinance when liquidity is removed,” says Richard Ford, head of European credit at Morgan Stanley Investment Management.

“The Funding for Lending Scheme was designed to provide liquidity and encourage people who are more likely to invest. What is hard to measure is what would happen if this liquidity was no longer provided.”

Some of the structures themselves are highly aggressive, such as Payment in Kind or PIK notes, such as that issued by Klockner Pentaplast. These instruments were last seen in large numbers in 2005-6. They do not pay any interest until they mature and rank low down on the queue of creditors in the event of a default.

CYPRIOT WOES

Investors are however concerned about the Cyprus bail in. “The big discussion has been about the Cyprus senior bondholders having a haircut,” says Mr Le Saout at Pioneer.

“We have been trying to get clarification as to procedure for resolution regimes and bail-in mechanisms. Only Denmark has established resolution procedures. Before Cyprus there had never been a case in the eurozone of senior bondholders not getting their money back. We are happy to hold very good Tier 1 and Tier 2 but would like clarification on this issue.T”

Some funds have taken an overweight position in financials as banks and brokers become the last bastion of value. For example, Invesco’s stance has been characterised by a conviction that banks will recover, and a big position in subordinated capital helped the fund return 15 per cent last year. “There is no doubt about the gradual rehabilitation of banks – just look at UBS and Lloyds results,” says Invesco’s Mr Aubrey-Johnson. “There is demonstrable progress with each passing quarter.”

Many fund managers are now overweight sovereigns in Italy and Spain in the belief they offer value after the turmoil of events such as the Italian elections. In particular, non-residents are looking at the eurozone and see that Spain is attempting to address its deficits and that its last budget was in line with estimates.

Minimising transaction costs is an attractive concept in this low volatility environment, and many managers have become less tactical. “In the past five years, there has been a change of styles,” says Morgan Stanley’s Mr Ford. “Liquidity in the market place has reduced and this impacts transaction costs and the benefits of actively rotating positions. We’ve always been a long-term value investor but we are now more willing to own securities through periods of volatility to maximise the liquidity premium being paid. The higher bid/offer costs of transacting and the lack of ability to transact in size mean the risks associated with tactical trading have increased.”

 But current high levels of M&A activity create opportunities around credit fundamentals where risks are mispriced, such as when corporate activity is taking place and the market overreacts to risks associated with the change in a company’s capital structure, says Mr Ford. “Another example is idiosyncratic M&A opportunities which are portrayed as imminent but do not occur and which can cause bonds to cheapen.” 

Wealth managers' view: Time to diversify

Fixed income has witnessed some of the best returns over the last 30 years, challenging the fundamental tenets of investing that higher risk leads to higher returns, according to Oliver Gregson, head of discretionary portfolio management at Barclays. “As a result,  we have just updated our forward looking views and we now expect yields to slowly normalise in developed economies and for central banks to slowly start unwinding some of the $10tn (€7.7tn) of stimulus.”

With sentiment and central bank support bolstering performance across risk assets, most corporate bonds have had a positive run year to date, and so, according to Mr Gregson, the question is, should one invest new capital now?

He suggests rotating from developed government bonds towards emerging market bonds and high yield, reflecting the better balance sheets of many of them.

“Given the additional yield spread and the benign environment for defaults, our bias remains firmly tilted towards corporate securities. For clients with a moderate risk tolerance, we are recommending 11 per cent in high yield plus emerging market bonds, and an underweight position (5 per cent) in investment grade,” says Mr Gregson.

“We still believe high yield offers compelling yield in the persistent low-rate environment. Corporate balance sheets are also robust enough to enable companies to make good on their liabilities. Given the current coupon rate on high-yield bonds we forecast total returns in the region of 6 per cent going forward.”

Faced with negative real interest rates and no respite on the horizon, ultimately, he believes one way to overcome inflation is to move money out of cash and real assets. “In pursuit of above-inflation returns, evidence shows investors benefit from holding a spread of investments not overly reliant on any one asset type.”

BNY Mellon Wealth Management is also advising greater diversification and recourse to real assets in the current fixed interest environment. “Recently we have been encouraging clients to hold more diversity in their portfolios, rather than holding primarily municipal bonds for their tax attractions,” says John Flahive, director of fixed income investments.

“We have morphed to a core and satellite approach to fixed interest in place of an emphasis on tax free municipal bonds. Given the level of interest rates and the acceleration in municipal credit risk and the tax risk associated with it, we have been telling clients to diversify across corporate bonds, emerging market bonds and aggressive municipal bond strategies  and also urging them to get out of cash and into short term bonds.”

Instead of a traditional 60/40 split, Mr Flahive is recommending a reduction in fixed interest to 30 per cent.

“Investors are looking for income everywhere in commodities, structured loans, mezzanine debt and large dividend equities,” he adds. “There is a real danger of investors being led into products that are seeking yield at the expense of capital.”

View from Morningstar: Financial benefits

The Morningstar EUR Corporate Bond category posted strong returns over the past 12 months (8.54 per cent in euro terms). This is particularly down to the risk-on environment over the second half of 2012, which benefited financial sector debt. Performance has been more muted over the first quarter of 2013 (0.51 per cent), as the situation in Cyprus and political instability in Italy sparked renewed concerns about the eurozone debt crisis. Funds which maintained a significant overweight on financials have tended to lag since the beginning of 2013, but many are still ahead of their peers over a 12 month period. 

One such fund is BlueBay Investment Grade Bond, which delivered 10.4 per cent. The fund’s unconstrained strategy relies on a wide range of performance drivers, including extensive use of credit default swaps. These can be used to tactically manage the portfolio’s exposure to the market, but also to build net short positions in issuers that the team believes will underperform. Although not without risk, the strategy has delivered good results, with the fund ranking in the first  decile of its category over three and five years.

AXA WF Euro Credit Plus AD EUR also ranks in the first quartile. The fund’s investment approach is very disciplined: sector bets, in particular, are closely controlled, and security selection provides most of the added value. At the end of 2011, the team anticipated the change in market sentiment, and re-positioned the portfolio on financials (senior debt), peripherals, as well as marginally on a few high yield issues.

Robeco Investment Grade Corporate Bond trailed the category average. The fund’s universe excludes financials, contributing to its resistance in the troubled markets of 2011, but penalising it in 2012.  

Mara Dobrescu, senior fund analyst, Morningstar France