In the wake of the sub-prime crisis, investors are not valuing all the risks captured in corporate bond prices in a consistent manner. Focus is generally limited to concerns over patchy liquidity, shrinking credit and further writedowns. As a result, the market is not pricing bonds in a discriminating manner at all.
The extent of investment opportunities varies through the corporate cycle but it is highest when there is little discrimination in the way the market is valuing the different kinds of risks in bond prices. In fact, in April’s financial stability report summary, the Bank of England commented that credit market prices appear to include large discounts for illiquidity and uncertainty and conditions should improve as investors recognise that some of these assets look cheap relative to credit fundamentals.
This kind of environment can be very supportive for high quality, investment-grade bonds. When the waters really start to muddy, select issues can shine through.
Whether the mini-rally in March and April was the start of a real recovery or just a relief rally, we used this opportunity to sell bonds that we are not comfortable retaining through the next two to three years.
More bad news could be just around the corner. The recent upswing suggests that the first phase of the corporate bond bear market, where all credit spreads widened significantly, has passed. After all, the US has fallen into recession and the banking sector has already gone through a lot of pain but has the low point passed? Or have the last nine months just been the tip of the iceberg? Is the bear market moving into its next phase, with the real pain yet to come?
We believe there are further buying opportunities to be found, credit markets seem vulnerable to more shocks and over the coming few months. Spreads between high quality and low quality bonds could diverge as weak sentiment and inflationary pressures continue.
Despite heavy intervention by major central banks, a lack of liquidity still remains a crucial issue. Credit spreads are still stretched as some bond investors are concerned that they may not be able to sell their bonds on and are demanding a greater risk premium to reflect this increased uncertainty.
Furthermore, the latest data releases continue to point to a deterioration in global economic activity and we do not expect to see any imminent reversal of this trend. Consensus forecasts have also been predicting that economic growth rates will come in at relatively subdued levels for the year.
Trends in the sporadically open new bond issues market suggest that further bad news may be coming. Industrial companies with little immediate need for up-front cash have been issuing debt in the last few weeks. Are they fearing bad times ahead and boosting their cash assets before the banks pull lines?
By and large, whenever leverage increases, defaults follow a few years later. The defaults of 1990/91 stemmed from the abundant corporate bond issue that fed the excessively geared leveraged buyout boom during the 1980s. Similarly, in the late 1990s, a lot of corporate bonds were issued to finance the highly leveraged TMT companies and then housed the defaults of 2001/02.
This time round, the heightened leverage appears to be in the household and leveraged loan sectors. Now it could be personal and corporate loan defaults which soar as much as, if not more than, corporate bond defaults.
Despite rising defaults and declining economic growth, we remain positive on the outlook for select corporate bonds. Throughout history, most investment-grade bonds do not default – even during a recession. We expect the volatility to run for some time as investors unwind layers of leverage but for the discriminating stockpicker, this could be an excellent time to buy cheap bonds.
Adam Cordery is manager of the Schroder corporate bond fund