Investors are concerned about several aspects of the corporate bond market, most notably valuations, relative supply and demand, and the degree of financial engineering.
Corporate bond spreads are tight when compared with historical levels, performing very well compared with gilts or other Government debt, but investors are wary of a rise in defaults, which would force corporate bond spreads to widen out.
Moody’s global 12-month trailing speculative default rate is 1.7 per cent. This compares favourably with 1.9 per cent at the beginning of 2006 but Moody’s is forecasting 2.5 per cent by the end of 2007 as high-yield issuers succumb to an unfavourable combination of leverage and slower economic growth. This is still well below the long term average of 4-5 per cent.
Also worrying is the high level of issuance of new corporate debt. Sterling credit issuance was close to a record £70bn in 2006, compared with £55bn in 2005 and a 10-year average of only £45bn. The emergence of leverage as a tool in financial markets has been important too, most obviously through the ability of companies to finance acquisitions and refinance debt at historically low rates.
Most of these reasons for being bearish have been around for some time. Our research suggests the prospects for credit markets are still moderately favourable.
Corporate earnings’ growth has been robust at this more mature stage of the business cycle so defaults have been low and relatively predictable. Another supportive feature of the credit market is that Government bond yields remain low.
Although inflation pressures have become more apparent in the past year or so, reflecting higher raw material costs and tighter labour markets, bond investors have been reassured central banks will not shirk when it comes to taking action to bring inflation back to target.
A third positive factor is the relationship between demand from bond investors and supply from corporates, driven by long-term trends such as low inflation, historically low market volatility or the changes to pension fund structure. There is every reason to expect these factors to remain in place and continue to support credit markets in the short term.
Looking ahead into 2007-08, the house view forecasts a harder economic landing than is being priced in by most investors. Historically, this has caused higher levels of volatility and problems for credit markets.
The advent of more bond defaults is likely to be the most testing or even the expectation of worsening defaults. A cluster of investment-grade defaults would be worrying news.
Any difficulties that emerge in the corporate bond markets would have an impact on associated asset classes. This would restrict flexibility and remove a bid floor from parts of the equity market, leading to growth in the popularity of low-risk assets, with investors moving back into cash, AAA money market instruments and gilts.
Our view still prefers corporate bonds over gilts in the short term, although caution applies further out. Triggers for investors would be a deterioration in underlying earnings’ growth, stronger than expected inflation, sharper than expected rise in default rates or a cluster of investment-grade defaults.
We have maintained our heavy position in US treasuries as we await the effect of Fed rate rises on the US economy. Falling inflation expectations encourage us to maintain our barbell position, with the addition of duration to our portfolios.
Relatively benign inflation prospects in Europe, and a continuing slant towards a tightening bias from the ECB in the wake of continued credit and money supply growth, encourage us to hold our heavy position in European bonds.
Our view holds a neutral position on UK gilts, which we expect to lag other government bond markets through early 2007. Demand for long-dated assets remains strong from pension funds and should continue to support our heavy positions at the long end of the yield curve.
Similar pension considerations apply to the UK indexlinked market, prompting us to increase our overseas index-linked bond exposure.
In the credit markets, the immediate outlook is positive for corporate bonds but in the medium term we will look for selective opportunities to increase our weightings in AAA bonds and reduce our positions in lower-quality debt.
Andrew Sutherland is fund manager of the AAA income and corporate bond funds at Standard Life Investments.