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Credit where it’s due

James Smith reports that after a stellar 2009, corporate bonds have fallen out of favour with investors but fund managers believe there is still fair value to be found in the credit market

John Pattullo: ‘We still see certain areas as cheap, including banks, where the opening of the Basel III regulatory committee in December appears positive for bondholders’
John Pattullo: ‘We still see certain areas as cheap, including banks, where the opening of the Basel III regulatory committee in December appears positive for bondholders’

By any measure, UK corporate bonds enjoyed a spectacular 2009, with funds producing equity-like performance and heading sales tables for most of the year.

Several managers highlighted lifetime-best opportunities to buy in the early months of the year, with markets pricing in unprecedented – and implausible – default risk.

Credit spreads had widened to Great Depression levels, with BBB debt yielding 7.75 per cent over gilts, and funds buying in benefited from a powerful subsequent rally.

Over the year, the average investment-grade credit portfolio was up by 17 per cent while median performance for high-yield funds was 37 per cent.

This was reflected in inflows, with sterling corporate bond funds outselling all other sectors for the first eight months of the year.

More recently, however, there are signs of a change in sentiment. Corporate bonds were the lowest-selling IMA sector in January, suffering outflows of £228m This is a sharp turn-round from last year which saw UK corporate bonds as the biggest-selling sector over the whole of 2009 and the most popular sector in the first eight months of the year.

But despite this recent aversion to traditional credit products, most managers still highlight pockets of value in the market and expect a reversion to more normal bond returns this year.

Invesco Perpetual’s co-bond heads Paul Causer and Paul Reed still prefer corporate over government bonds, highlighting risks to medium-term returns in the latter, given the increase in supply. “Although we do not expect to see a repeat of last year’s strong gains, underlying conditions are still supportive of credit markets.”

Within credit, they say defensive sectors such as utilities and energy are no longer offering the value of a year ago and expect capital returns in these areas to be more modest.

But the pair continues to see value in higher-yielding investment-grade names and better quality high-yield issuers. They say: “Spreads remain relatively generous by historical standards and we believe credit is attractive for income-seeking investors prepared to take a medium-term view.”

Causer and Reed particularly highlight insurance and financials where yields and spreads both remain attractive, at over 6.5 per cent in aggregate.

On subordinated financials, spreads remain well above historical levels with yields typically around 7 per cent10 per cent on tier-one debt.

David Roberts: ‘At present, we continue to view the beta in high yield as less attractive than for investment-grade although high yield can post sup erior, non-risk-adjusted returns’
David Roberts: ‘At present, we continue to view the beta in high yield as less attractive than for investment-grade although high yield can post sup erior, non-risk-adjusted returns’

They say: “Bank debt has performed exceptionally well from the lows in March 2009 and there are many examples of bonds that have more than tripled in value. Nevertheless, despite the beginning of a recapitalisation of the banking sector and a better understanding of the risk of holding these bonds, we believe there remains an opportunity for further improvement.”

With spreads now back to typical recession levels, most managers predict an environment of more careful credit selection rather than the whole market rallying.

Investec sterling bond fund manager John Stopford says valuations in credit are largely fair and as long as economic growth continues to improve, spreads should tighten. “However, we foresee more volatility in 2010 versus 2009, which should make investing in the right names and sectors even more important than last year.”

Once again, banks are Stopford’s biggest exposure, believing a recovery in the sector is key to the global economy as well as credit markets.

He says: “This recovery in bank spreads is under way and should gather momentum as the economy continues to improve. Within the banking sector, we have rotated out of higher-priced tier-one securities whose high back-end coupons are unlikely to materialise, as we feel issuers are likely to call, buy back, the securities. Instead, we have moved into lower-priced securities that offer more upside if they are bought back by the issuer.”

Henderson preference and bond fund and strategic bond fund co-manager John Pattullo says strategic funds may be better placed than UK corporate bond funds to deal with economic uncertainty. His team is another seeing little value left in industrial sectors and prefer financials – with bondholders set to benefit from tighter regulation.

Pattullo and co-manager Jenna Barnard also like crossover names such as ITV and Daily Mail that sit between investment-grade and junk status.

James Smith reports that after a stellar 2009, corporate bonds have fallen out of favour with investors but fund managers believe there is still fair value to be found in the credit market

Overall, Pattullo says implied default rates now suggest credit markets are fair value and they are clearly some way from the cheapness of early last year.

He says: “Credit markets have continued to outperform, explained in part by continued strong inflows into the market and expectations of a rapidly declining default rate. We still see certain areas as cheap, including banks, where the opening of the Basel III regulatory committee in December appears positive for bondholders. Regulators are focusing on increasing the amount of capital held by banks, making them less leveraged and more utilitylike – the kind of companies we prefer to lend to.”

Looking forward, Aegon Asset Management co-head of bonds David Roberts highlights three fears currently prevalent in fixedinterest markets, namely inflation, a double dip or a period of inertia.

Roberts also says strategic bond products may be better placed than corporate bond funds to navigate all of these conditions and says, in a recessionary environment, strategic funds offer the option of moving heavily in to government debt.

To mitigate the current risks in corporate bonds, he would consider buying back some of the very high quality investment-grade bonds sold in recent months, such as Procter & Gamble, ConocoPhillips and GlaxoSmithKline.

Finally, with anaemic growth, Roberts would simply add to holdings in high-yield and investment-grade bonds.

Roberts says: “At present, we continue to view the beta in high yield as less attractive than for investment-grade – although high yield can post superior, non-risk-adjusted returns. If we had greater certainty on economic recovery and that suggested a long, slow path back to trend, this would alter our perception. The ability of high-yield companies to earn or cost-cut their way forward is well proven – a US growth rate of around 2 per cent is cited as the sweet spot for the asset class.”

Simply clipping the coupon on high yield and investmentgrade would currently deliver somewhere between 7-10 per cent and, assuming CPI at 2 per cent, Roberts said real returns between 5-8 per cent a year may not be too bad.

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