The corporate bond market performed very well in 2003, benefiting from improved global economic prospects, improved cashflows and balance sheet prudence as companies reduced their debt burdens.
However, sentiment towards the market took a knock over the first quarter of 2004 as the economic recovery slowed and investors feared that corporate bond spreads – the yield advantage over governments – had tightened too fast. The prospect of rising interest rates in the UK and abroad further weakened sentiment.
Nevertheless, while we do not expect such widespread gains in 2004, we see no catalyst for an aggressive widening in corporate bond spreads. Instead, we expect the market to trade in a reasonably tight range but strong returns are still possible.
However, while overweighting the market – lower-rated credits in particular – was enough to achieve strong returns last year, this strategy is unlikely to reap significant returns over the course of this year. As managers are forced to “sweat” their portfolios, selectivity will be key, as choosing the right credits will be the key driver behind performance.
During 2004, we believe active management will be essential. As well as adding value through stockpicking, we expect that opportunities will also be available from active duration and curve positioning although timing, and possibly patience and stubbornness, will be key here.
Understanding stocks is essential for successful, stockpicking and research is vital in understanding credits. After all, the key to corporate bond investing is to avoid the losers and find opportunities to add value. Fundamental research must be carried out on every credit in a portfolio and choosing a manager with strength and depth in research capabilities is essential.
Where are the opportunities? Those managers that have looked at bonds denominated in currencies other than sterling have been able to add considerable value this year. The sterling market is fairly unusual and looking at other currencies often produces good arbitrage opportunities. Hedging overseas bond investments back into sterling has offered a significant yield enhancement so far this year and should continue to do so. In addition, looking outside the relatively small UK market broadens the universe of potential investments and the opportunities to add value. As managers have to squeeze returns through stockpicking, the wider the potential investment universe the better. Longer-dated European bonds are a good example of where we have been able to add value outside the UK this year.
As well as broadening their focus to bonds outside the UK, some managers are also looking at the growth of new products, for example CDs, CDOs, hedge funds and structured products. Investors in Europe have rapidly taken to these new products but UK investors have generally been slow on the uptake. There are opportunities to add value in these relatively new and relatively unexplored markets.
The release of CP195 – the consultation paper outlining realistic solvency requirements for UK with profits insurers – has also created opportunities. Expectations of higher capital requirements for longer-dated, lower-rated corporate bonds have led to significant underperformance of these bonds and an aggressive steepening of the credit yield curve.
Some of the underperformance has been justified but we feel that the impact of the proposals on the wider market has been exagger-ated. Capitalisation is tight for some with-profits funds but the problem is by no means endemic.
With long-dated supply down significantly this year and redemptions increasing, we see compelling technical factors behind much of the drag on longer-dated valuations. Portfolio strategy being driven by legislation is not what we believe the FSA intended and we expect to see some support for longer-dated spreads in the months to follow.
With spreads so tight after last year's rally, predicting interest rate movements will also be a key driver behind performance, as the Bank of England has already demonstrated its willingness to raise rates. Simply overweighting lower-rated credits will not be sufficient to generate substantial returns within credit portfolios this year. A manager's ability to anticipate government yields or interest-rate moves successfully will be vital in achieving strong returns over the course of the year.